Wednesday, January 18, 2012

>INDIA STRATEGY: Preserving Capital- Best Risk - Reward Bets

To read the report: INDIA STRATEGY


>PUNJ LLOYD LIMITED: Has ~Rs39bn worth of orders from Libya and set to start execution in 1-2 months

■ Takeaways from Mumbai – Punj Lloyd presented at our India Infrastructure and Industrials Conference in Mumbai on 10-11 Jan. Below we highlight key takeaways.

 Steady improvement in operations – Company has gone through a rough patch over the past one year, but says things are under control and improving. No new issues (auditor qualifications / customer disputes) have emerged in recent times, and losses in Simon Carves are over.

 Libyan orders set to start execution in 1-2 months – Based on the situation on the ground, company believes that it will be able to start execution of Libyan orders in 1-2 months. PLL has ~Rs39bn worth of orders from Libya.

 Orders and margins – PLL has won Rs120bn of orders in YTD FY12. Current order backlog at similar to those reported in 1HFY12 numbers. Company targets >10% margin at project level. 30% of projects have price variation clause for raw materials.

 Outlook on different sectors – (1) Power BOP – Company has won orders from GVK, CESC and KSK, but order inflow is now slow given problems in the power sector. (2) Pipeline – Average annual market size is Rs25bn, of which PLL has 25% share. This market is likely to increase to Rs40bn/yr. (3) Oil and gas onshore EPC – Slow as of now, but some projects which had been deferred are now being revived. The
addressable market size is Rs40-50bn/yr. (4) Tanks and Terminals – There is substantial activity in tanks and terminal space. Over next two years, 8-10 strategic oil reserves projects (each of Rs8-10bn) are likely to be given out. There are a number of LNG terminals and tanks orders from these which could be in the Rs2-4bn range each.

■ Balance sheet and working capital – Current debt is ~Rs51.5bn with average interest cost of ~11%. ~29% of debt is denominated in foreign currency compared to ~70% of revenues in foreign currency. As a result, company is looking to substitute high-cost INR debt with foreign currency debt to reduce interest cost. Currently company has ~Rs15bn receivables pending due to various reasons (~Rs4.9bn from ONGC + Rs3bn in India from OMCs and others). Oil marketing companies (OMCs) have delayed payment due to stress on their financials, which has resulted in some pressure on working capital.

To read the full report: PUNJ LLOYD

>LARSEN & TOUBRO: High investments in non-core and long gestation businesses

Best positioned to tide over the slowdown

 Growth slowdown inevitable, but concerns exaggerated: L&T is one of the most diversified and the largest E&C player in India. It has far out-paced competition particularly on profitability thanks to 1) its highly integrated operations, 2) strong preference from private sector clients, 3) economies of scale, and 4) stringent risk management and controls. We believe that the concerns on slowdown, though not unfounded, but are exaggerated given 1) high order replacement ratio (>1.3x) despite sluggish environment, 2) superior cash flow generation and 3) strong long term potential.

 Re-focus on globalisation – a step in the right direction: While L&T is considered one of the largest E&C players globally; it derives only c.10% revenues from international markets. However, with domestic outlook weakening substantially, the company has stepped up efforts in overseas markets, primarily Middle East. While this presents several near-term challenges, primarily stiff competition from Korean and European counterparts (much larger presence and are well entrenched in these markets), it will provide important geographical diversification, which is a step in the right direction in our view. The efforts have also started to pay off with some important break-through in the last year or so.

■ Near-term earning expectations need to be reset lower, but core returns healthy: Current earnings expectations need to be reset lower, in our view; we highlight that our standalone EPS estimates are c.11% below consensus as we have built in conservative set of assumptions on order inflows, margins, asset utilisation etc. While core business returns are set to decline from current levels (RoIC at 32.3% in FY11), they should remain enviable and healthy (we estimate c.22% in FY13-14E period).

 Stock cheap by historical standards, opportunity to enter: After the recent correction, stock is trading at 11.7x FY13E EPS (adjusted for conservatively assigned values to non-standalone businesses), which is c.15% discount to Sensex (vs historic premiums of over 25-30%; the discount is similar to the ones during 2009 bottoms). We believe valuations have more than factored the impact of slowdown, while long-term fundamentals remain strong. We initiate coverage with BUY and Dec’12 TP of `1,275.

 Key concerns: 1) High investments in non-core and long gestation businesses, 2) impending changes in business structure, 3) continuing deterioration in macro environment.

To read the full report: L&T

>MUTUAL FUNDS REVIEW: Institutional fund flow, Equity funds, Equity diversified funds, Equity Midcap Funds, Equity Infrastructure Fund, Equity Banking Funds, Arbitrage Funds, Exchange Traded Funds (ETF), Balanced Funds, Monthly Income Plans (MIP), Debt funds, Liquid funds etc..

  • The year 2011 has been a volatile one where factors such as the ongoing Euro zone sovereign debt crisis, slowdown fears in the US and higher than anticipated jump in inflation in BRIC countries impinged on the global growth ecosystem
  • The one theme that is consistent across various asset classes is safety first. Risk aversion remained at elevated levels forcing investors to dump riskier assets(global equity markets, riskier bonds and commodities) and resort to perceived safe havens (US treasuries, gold)
  • Going into 2012, sentiments remain weak due to persisting European sovereign concerns and impact of any negative development
  • We expect more of a time based correction and expect the markets to oscillate in a broad trading range till the time reasonable clarity emerges from various local and global macro headwinds
  • In case of a negative outlier event, the markets may fall further in the wake of panic selling. However, we do not expect the markets to sustain at such levels. In such an environment, timing the markets would become extremely difficult. We believe that any sharp cuts should be bought into from a three to five years perspective. Currently, higher allocation should be made in large cap funds with some allocation to midcap funds depending upon risk appetite
  • We believe at least H1CY12 will be volatile as the markets would witness huge swings to the news emanating from the emerging and western world. Also, the markets will react sharply to any surprise coming from within the country on the political/economical front. Such bouts of volatility will provide a platform to accumulate equities in a staggered manner as we expect H2CY12 to be a more trending one as a lot of macro issues may subside
  • In the short term, the fortunes of equities are also tied to the relative attractiveness of fixed income, gold and real estate. Any deterioration in the risk-return trade-off in these asset classes would be a blessing in disguise for equities else equity markets may continue to be sidelined
  • We expect the year end target for BSE Sensex to be boxed in the range of 15442: 14x FY12 Sensex EPS of 1103 ((bear case)– 17822: 4x FY13 Sensex EPS of 1273 (base case) in line with earnings growth of 15% in FY13 and historical average multiples of 14x
  • Since we are currently trading at close to our bear case year end target, equity investors with an investment horizon of more than one year should start allocating fresh money as the long term case for investments in Indian equity markets still remains intact.

To read the full report: MUTUAL FUNDS

>SOBHA DEVELOPERS LIMITED (SDL): Has not launched any new project in 3QFY12 and has given muted new project launch

Strong 3QFY12 pre-sales, but no new project launch a concern
Sobha Developers (SDL) reported strong pre-sales of Rs4.4bn (up 47% YoY) in 3QFY12, thanks to sales from Gurgaon project, but they were down 7.8% QoQ on lack of new project launch. Although reported pre-sales of Rs12.3bn and 2.4mn sq ft in 9MFY12 were ahead of our expectations, we believe higher net debt (net D/E ratio of 0.71x in 2QFY12) will remain an overhang on the stock. Further, SDL has not launched any new project in 3QFY12 and has given muted new project launch guidance of 1.6mn sq ft for 4QFY12, which will make sustainability of 3QFY12 pre-sales challenging. We maintain our Hold rating on SDL.

Strong pre-sales; likely to surpass its FY12 guidance: Volumes stood at 818,935 sq ft, up 16.2% YoY, but down 12.5% QoQ. Average realisation was Rs 5,475/sq ft, up 5.4% QoQ, aided by better product mix. The management has indicated that the company will surpass its pre-sales guidance of Rs15bn and volume guidance of 3mn sq ft for FY12, which, we believe, is achievable. However going forward, sustainability of strong pre-sales will be challenging, given the lack of new project launch in Bangalore.

No new project launched in 3QFY12: SDL had done 3.1mn sq ft of new project launch in 1HFY12 (across Bangalore, Gurgaon and Mysore) and had given muted guidance of only 1.6mn sq ft for 2HFY12 because of lack of new projects in Bangalore. Further, the ongoing delay in getting government approvals in Chennai resulted in no new project launch in 3QFY12. The management has given guidance of launching Sobha Serene (0.2mn sq ft) and Sobha Meritta (0.7mn sq ft) projects in Chennai and Hopefarm project (0.6mn sq ft) in Bangalore in 4QFY12.

Higher debt remains an overhang: SDL had reported positive operating cash flow of Rs891mn in 1HFY12, but adjusted for capex (Rs558mn) and interest payment (Rs1,230mn), debt reduction seems to be unlikely. Further 50% of its debt is front-ended, which makes it vulnerable in a scenario of high interest rates. Going forward, we expect muted debt reduction visibility (the management gave guidance of Rs3bn debt reduction in FY12) because of no land sales, stake purchase from PAN Atlantic for Rs600mn and high pre-launch expenses in markets other than Bangalore.

Outlook: At the current market price, SDL is trading at 0.9x P/BV and 8.8x P/E on FY13E earnings and at 36% discount to our one-year forward NAV. Muted visibility on debt reduction and higher new project launch in new cities offsets 30% discount to NAV. We maintain our Hold rating on SDL with a TP of Rs227, which is at a 30% discount to our one-year forward NAV.

>KEC International: Likely to continue to witness strong order growth in its new businesses (i.e., power systems, water, cables and telecoms) as the company ramps up from the current low base.

Strong visibility on revenue growth. KEC today announced new orders totalling INR12.5bn, taking the total order book to INR90bn (c2x FY11 sales). The order book is likely to drive strong revenue growth of 20-25% in FY12-13e, as the majority of these orders are scheduled for delivery over the next 18-24 months. In addition, management noted that the tender pipeline remains strong, both in domestic and international markets. Other sector players have made similar comments and believe that there is strong visibility on at least domestic transmission orders, as Power Grid is likely to ramp up its ordering activity. In addition to transmission, KEC is likely to continue to witness strong order growth in its new businesses (i.e., power systems, water, cables and telecoms) as the company ramps up from the current low base. Overall, KEC now appears likely to outperform our sales growth forecasts of 23% for FY12 and 19% for FY13.

FY13 profitability likely to beat estimates. Management estimates the overall margin on the new orders announced today at c10%. While the margin on the transmission business is likely to remain stable, the margin on new businesses is expected to continue improving (as the new orders demonstrate). Our current estimates are for the overall margin to contract from 10.8% for FY11e to 9% in FY12e due to mark-to-market losses booked in Q2 before expanding slightly to c9.7% in FY13 (versus the consensus estimate of c9.6%).

The new orders, however, suggest that KEC may beat these estimates, registering a margin of c10% in FY13. Overall, we see potential upside to our estimates going into FY13, with the biggest, albeit unlikely, risk being a further depreciation in INR. Attractive value. Our current forecasts call for EPS to surge c43% in FY13e and 38% in FY14e after a decline of c8% in FY12e, driven by the normalisation of margins due to a reversal of mark-to-market losses, the risk to which remains low. With such strong, resilient growth and a large order book, the stock’s valuation looks attractive at a c3.5x FY13e PE; therefore, we reiterate our OW rating and target price of INR80. Our target price is derived from our preferred EVA valuation methodology and implies a 12-month forward target multiple of c6.4x PE on a 24-month forward PE of INR12.5. We believe that the quarterly growth in earnings, continued order announcements and peaking of the interest rate cycle could act as key catalysts for a stock re-rating.

Valuation and risks
Our target price of INR80 is derived from our preferred EVA valuation methodology, assuming target sales growth of c9%, through-the-cycle operating return margin of c9.5% and WACC of c12.3%. Our target price implies that 12 months from now the stock should be trading at a 12-month forward PE of 6.4x (compared to the current 12-month forward PE of 4.2x) on 24-month forward EPS of INR12.5. Under our research model, for stocks without a volatility indicator, the Neutral rating band is 5ppt above and below the hurdle rate for India stocks of 11%. Our target price implies a potential return of 122.5% (including a dividend yield of 3.3%), above the Neutral band; therefore, we are reiterating our Overweight rating. Potential return equals the percentage difference between the current share price and the target price, including the forecast dividend yield when indicated.

Key downside risks related to our investment case include:

  • Delay/cancellation of transmission projects
  • Excessive pricing pressure
  • INR depreciation or commodity hedging-related losses.

>INDRAPRASTHA GAS LIMITED: Prices charged for CNG & PNG by IGL include a marketing margin component

Marketing margin to be capped?
Media reports indicate that the central government has entrusted PNGRB with the determination of quantum of marketing margin chargeable on sale of natural gas to end consumers by a marketing entity on the basis of marketing costs incurred by it. Currently, GAIL charges marketing margin of ~$ 0.18/mmbtu on PMT, ~$ 0.12/ mmbtu on APM gas and ~$ 0.7/mmbtu on non-APM gas and LNG. RIL charges $ 0.135/mmbtu for KG D6 gas. Petronet LNG charges ~$ 0.4/mmbtu as marketing margin for spot LNG cargoes. Prices charged for CNG & PNG by IGL also include a marketing margin component.

Scope of regulations limited to domestic gas
The primary target for capping marketing margins would be domestic gas producers & marketers since customers for domestic gas are earmarked & allocated by the Govt. Thus, there are no marketing costs incurred in the process. However, it is not clear whether the current set of rules & regulations are applicable on CGD & LNG terminals. Importing spot LNG from the global market requires an ability to source competitively priced LNG. Also, the company makes its own efforts for identifying customers and signing offtake agreements with the same, which involves considerable resources. CGD companies have to make investments in pipelines, CNG stations, spur lines to ensure last mile connectivity to reach out to new areas and add more customers. Hence, we believe that LNG terminals & CGD companies would not be treated similar to passive sellers of domestic gas.

Implementation to take time
The PNGRB is yet to be fully constituted only after which it can pursue long pending issues related to authorization of transmission networks, transmission tariffs (GSPL), CGD rollout; besides the latest issue of linking marketing margins to marketing costs. PNGRB would also likely invite the various companies to present their case and evaluate the same. Meanwhile, it would also obtain opinions from other Govt. agencies on the scope and ambit of the current regulatory structure. Ultimately, the whole process would take a lot of time.

IGL looks attractive
We had initiated coverage on IGL in Oct 2011 with a contra-consensus SELL call, citing risks to continuance of the past rosy growth & margin scenario. Subsequently, the stock has corrected from Rs 426 at the time of our initiation to Rs 327 currently. Prior to the news flow regarding clamping down on marketing margins, the stock had fallen due to margin pressure resulting from increased dependence on spot LNG and steep rupee depreciation. Price hikes by the company have proved to be insufficient to protect margins. Accordingly, we have revised our estimates downward with FY12E & FY13E EPS going from Rs 25.2 & Rs 27.8 to Rs 19.8 & Rs 22.4 respectively. At the current market price, the stock looks attractively valued @ FY13E P/E of 14.6x and we upgrade our recommendation to a trading BUY at current levels and on dips with a target price of Rs 366.