Bhushan Steel

Higher demand for flat products and expansion in operating margin will benefit Bhushan Steel in the near term

THE recent recovery in Indian economy has once again increased the demand for steel products. There has been significant rise in auto sales and other consumer goods in last few months. All these factors have led to a rise in sales of flat steel products. Bhushan Steel, a leading producer of flat products, is set to benefit from all these. The gains will be driven by faster topline growth coupled with backward integration, which will lead to significant improvement in operating margins. Investors with a mid-term horizon of 2-3 years can add this stock to their portfolio kitty.

BUSINESS :

Bhushan Steel is a secondary steel producer and mainly produces value added flat products. It gets more than twothird of its revenue from cold rolled and galvanized steel products. Bulk of its revenue comes from the automobile and white goods sector, which uses the flat products predominantly. It has three plants, located strategically in different parts of the country. The Dhenkanal plant in Orissa is close to the raw material source and manufacturers sponge iron and billets, the primary steel products. The Khopoli plant in Maharashtra and Sahibabad plant in Uttar Pradesh are close to the two auto hubs in India namely Pune and Gurgaon. These two plants primarily manufacture cold rolled and galvanized products used by the auto companies. It has a close to one million ton capacity for cold rolled products, which is used as a key input for other value added products.

FINANCIALS:

The company's topline has almost doubled in last four years to Rs 5,000 crore in FY 2008-09. The net profit, however, grew at a faster rate during the same time period.

For last four years, the company has been making significant capex to link its operations backwards and to become more integrated. Bulk of this capex program is being financed through debt. As a result, its debt-equity ratio has increased close to four, from the two earlier. This is not a major concern given its higher interest coverage ratio (more than 5). The company has expanded its operating margin by around 500 basis points over last two years to 20.4% in FY 2008-09. In fact, its operating margin in September 2009 quarter increased to around 26%, thus reflecting the partial impact of backward integration. Its return on capital employed (ROCE) of 10% for last several years appear to be lower. But this is a result of higher capital expenditure made during the same time period.

GROWTH DRIVERS:

The company plans to make a structural change in its business model to become an integrated steel company. The management feels that at a time when primary steel producers are planning to produce more value added products, it is imperative for the company to integrate itself backwards to remain competitive in secondary market. The integration process itself will be completed in two steps. In first step, the company will set up around 2 million tons of hot rolled coil (HRC) and 0.3 million tons of slab capacity by this year-end. The HRC capacity will be further augmented to 5 million tons by FY '13. In second step, the company will start mining iron ore and coal from the mines allocated to it. This process will take around 4-5 years. Hence, the full impact of integration, from mining to value added steel products, can be seen from FY '14 onwards. The company has already spent 50% of total capex required for all these expansion programs.

VALUATION:

The full impact of first phase of expansion will start flowing into the financials of the company from FY '11 onwards. As a result of this backward integration, its net profit margin is expected to rise to 15-16%, from the current 9%. This will also boost the company's operating cash flow significantly.

The earning per share (EPS) for FY '10 and FY '11 is estimated to be Rs 171 and Rs 243 respectively. At the current price level, the forward price-earning multiple works out to be 7.9x and 5.6x for FY '10 and FY '11 respectively. The company's scrip has always traded at a P/E multiple in the range of 13-17 during good times. This provides significant upside potential for investors with a horizon of 2-3 years.

ICRA

ICRA’s rich valuations don’t look expensive considering the high growth trajectory and robust fundamentals
CREDIT ratings agency ICRA has grown by leaps and bounds in the last three years. Though much smaller than the market leader, Crisil, the company is a prominent player in the rating industry. Since it is in the services industry, which does not require huge investment in fixed assets, its return on capital employed (RoCE) at 31% for FY 2009 is quite high.

BUSINESS:

Apart from credit rating, which accounts for a major part of the company’s revenues, ICRA is also into consulting and outsourcing services. There is great scope for growth in the ratings business in India for several reasons. Corporate bond market is highly underdeveloped in India. There are entry barriers in the form of brand name and expertise. And finally, there are just four big players in the industry—Crisil, ICRA, CARE and Fitch (India). The recent regulations of the Reserve Bank of India (RBI), according to which any company borrowing more than Rs 10 crore from a bank has to be rated, has given a fillip to ICRA.

Already its rating business is growing fast. ICRA’s rating revenues grew by 28% in June ’09 quarter. Indian companies require huge investments in projects and need to raise funds from various classes of investors to meet their needs. This will increase their dependence on the bond market. Through its subsidiary, ICRA Management Consulting Services (IMAcS), the company has also entered into consulting, wherein it provides services to companies in various industries such as banks, automotive, health and retail. Though last year the consulting business was affected by slowdown, it is set for a revival this year after the improvement in sentiment and increase in investments.

The company also has a presence in outsourcing services as well. In brief, the company has presence in a whole gamut of rating, consulting and BPO related businesses, which are the growth drivers of future.

FINANCIALS:

The company can grow its profits without substantial investments in fixed assets. For instance, its revenue has grown at a compounded annual growth rate (CAGR) of 40% in last three financial years. In the similar time frame the balance sheet grew at a CAGR of 25%. This is typical of companies, which are not asset heavy, wherein more returns can be earned from little investment. For this reason, RoCE has improved from 16% in FY 2006 to 31% in FY 2009. Moreover, the company has always been debt free, which results in better cash flows.

VALUATIONS:

The stock is trading at a price-to-earnings (P/E) multiple of 19.5 times.

Though, the valuations don’t look cheap, but factoring a high RoCE, it would look modest. The company is growing at a very fast rate — its profit jumped 73% in June ’09 quarter. Definitely, the valuation doesn’t look expensive in the context of growth trajectory. Historically, the stock has traded at very high valuations. For instance, in June 2007, the stock was trading at 45 P/E and then in December ’07, it was trading at a P/E of 40. This shows that the stock still has scope to catch up at current valuation.

Hindustan Zinc

Falling cost of production, new capacity addition and huge cash reserve makes Hindustan Zinc a good medium-term bet
BASE metal prices have picked up over last six months, thanks to the improved optimism worldwide about a speedy economic recovery. But the road to recovery is paved with caution, and hence investors should cherry pick a stock from the base metal sector which offers good growth potential but with limited downside risk.

Hindustan Zinc is one such stock, which we recommended and predicted the bottoming out of zinc prices at that time. Since then, the stock price has more than doubled. Recently, the company reported a good quarterly result and is on track with its expansion plans. Its lower cost of production and huge cash and liquid investment reserve on its balance sheet makes it an attractive investment bet. Its new smelting capacity of 3 lakh tons, expected to be commissioned by mid-2010, is well timed with demand recovery. Mediumterm investors with a horizon of 2-3 years can add this stock to their portfolio.

BUSINESS

Hindustan Zinc is the largest zinc-lead producer in India with a market share of more than 80%. It is fully integrated having its own mines and power plants. The company’s total mining reserve and resources is estimated at around 272 million tonnes which contain different grades of zinc and lead content ranging from 5-13% and 1.5-3% respectively. It mines nearly 7 million tonnes of zinclead ore every year. Similarly, the company has smelting capacity of 0.75 million tonnes which operated at a capacity utilization of 80% in FY ‘09. In addition to these non-ferrous metals, it also produced around 105 tons of silver, which is a by-product of the core operation. It also sold around 1 million ton of sulphuric acid, a by-product, during same time period.

FINANCIALS

The company is one of the lowest cost zinc producers in the world, thanks to its raw material integration plan and better operating efficiency. Its operating margin, even in current market scenario, stands at more than 50%. Its average return on capital employed (ROCE) for last five years is close to 50%, much higher than many companies across different sectors. Hindustan Zinc has a target to bring down the cost of production to $550 per ton from the current sub $700 per ton level and that would further improve its operating margin substantially. It has a cash and cash equivalents of more than Rs 10,000 crore and zero debt on its balance sheet as on 31st March, 2009.

FUTURE GROWTH PLANS

The company plans to be one million tonne integrated lead-zinc producer in next two year time period. To achieve this target, the company is also expanding the capacities of different inputs like power and zinc-lead ore. It is setting up a power plant with a capacity of 160 MW and also increasing the mining capacity close to 10 million tonnes per annum. The silver production capacity would also increase to 500 tons per annum, from the current 150 tons per annum, boosting the profitability further since it is doesn’t add any further cost to main production process. The total investment required for this purpose is estimated at around Rs 3,600 crore which would be financed from internal accruals.

VALUATION

The company’s profitability in next two years would significantly increase because of lower cost of operation, higher volume and increase in realization. The impact of its additional 3 lakh tonnes capacity will be visible partly in FY ’11 and fully in FY ’12. The earning per share for FY ’11 and FY ’12 are worked out to be Rs 105 and Rs 135 respectively. At the current price level, this translates into forward price-earning (P/E) multiple of 6.9 and 5.4 respectively. This provides a significant upside potential for a stock, which traditionally trades at a P/E band of 10-14. Also its huge cash and cash equivalent on balance sheet translates into Rs 237 per share and limits the downward risk. Investors with a time horizon of 2-3 years can consider this stock for their portfolio.

Torrent Pharma

While FY08 was under pressure due to losses registered by its German arm, Torrent Pharma is showing signs of recovering to a profitable FY10
GIVEN its performance and growth potential, Torrent Pharma is a relatively under-valued stock in the Indian pharma space. However, the stock has out-performed the broader indices in the past 12 months. While the Sensex declined by over 40% last year, the stock is trading around the same level.

The company has been on a growth path in the past two fiscals. While the losses registered by the German subsidiary adversely impacted its overall growth in FY08, the company is showing signs of a recovery and is likely to bounce back by FY10.

Business:

Incorporated in 1972, the Ahmedabad-based Torrent Pharma is engaged in the production of drug formulations and contract manufacturing. The domestic branded formulations, exports and contract manufacturing contribute 44%, 45% and 11% to the company’s total revenues respectively. The company has a strong presence in the high-value chronic therapies of cardio vascular, gastrointestinal, central nervous system (CNS) and anti-diabetes. The company’s top 10 brands constituted 41% of its total domestic formulation sales in FY’08 as against 44% in the previous year.

Torrent’s major international operations are situated in Brazil, Europe, Russia and the former Soviet republics in Eastern Europe and Central Asia. It has nine wholly owned subsidiaries in various regulated and semi-regulated markets abroad. The pharma company’s other revenue source is contract manufacturing, which largely comprises of sourcing, manufacturing and supplying insulin formulations under a third-party brand name.

Torrent is steadily ramping up its product development activity. Research and development (R&D) expenditure account for 7% of its revenues, with a 70:30 spend ratio towards product development and discovery research. The company has a healthy product pipeline for the US and European markets on expiry of the patents. It also undertakes new drug discovery research and currently has seven new chemical entities (NCE) in diabetes and related ailments.

Growth Strategy:

The domestic formulations business and operations in the semi-regulated markets of Brazil, Russia and countries in Eastern Europe and Central Asia are the growth drivers for the company. These markets are witnessing a double-digit volume growth. The company is bullish on its international generic business. Many of its international operations have achieved critical size, leading to revenue traction.

Torrent’s domestic business also benefits from the tax-free status enjoyed by its manufacturing operations. Its units, located at Baddi and Sikkim, enjoy tax exemption for 5 and 10 years respectively. This enables it to compete effectively in a pricesensitive market.

Financials:

The company’s net sales rose at a compound annual growth rate (CAGR) of 28.7% over the past five years to Rs 1355 crore in FY08. The net profits have grown at a CAGR of 25% to Rs 134.6 crore in FY08. At an average dividend payout of 25% over the past three years, the company’s dividend payouts have grown at a CAGR of 12% over the past five years, half than the corresponding profit growth. The company has positive operating cash flows and a debt equity ratio lower than one.

The company’s sales growth in FY08 was weighed down by de-growth in its German subsidiary Heumann in wake of severe price erosions and a volume shift to unexplored segments. The company expects to shift 70-80% of Heumann’s manufacturing to India. The subsidiary is thereby expected to break even in FY10.

The past twelve months have reflected the recovery in the company’s operations and profitability. The position is likely to improve going forward. Recent measures such as realignment of field operations, cost-cutting, and shifting of manufacturing from Germany to India are expected to beef up the profit margins.

Valuations:

Torrent has outperformed the Sensex and is currently valued at little over its annual turnover. It witnessed a stable 22% return on capital employed (ROCE) over the past two years. It is an under-valued stock among similar-sized peers and holds promise for investors looking for value in the mid-cap space.

Castrol India

A high dividend yield, stable business and sound financials make Castrol an attractive pick for long-term investors. It’s a must-have defensive bet during tough times

Beta: 0.41
Institutional Holding: 13.5%
Dividend Yield: 4.6%
P/E: 13.7
M-Cap: Rs 3,739.5 cr

AROBUST balance sheet, sound business model and strong brand equity of its products is enabling Castrol India to churn out good cash flows year after year. Even amidst a slump in the automobile sector, the company’s lubricants will still have a large potential market to tap.

In the past five years, there has been a dramatic increase in the number of cars and commercial vehicles on India’s roads. This aftermarket is likely to be a big growth driver for the lubricant industry in general and Castrol in particular, over the next few years. With a year-on-year outperformance of 10%, Castrol is a must-have defensive stock during difficult times.

BUSINESS:

Castrol India is the Indian subsidiary of UK-based Burma Castrol and is engaged in manufacturing and marketing of automotive and industrial lubricants and specialty products. It operates in the automotive as well as nonautomotive segments. The former includes oils for heavy-duty vehicles, cars, motorcycles and bikes, while the latter includes industrial lubricants, marine and energy lubricants and the services segment.

Public sector players like IndianOil, Bharat Petroleum (BPCL) and Castrol account for around 70% of the domestic lubricants market. Several other players, including global majors, account for the balance share, resulting in a highly competitive market. Besides having technologically superior products, Castrol also has strong distribution network and brand recall. The company is the market leader in the retail segment with a share of around 21% in the total automotive lubricants market.

GROWTH STRATEGY:

Castrol has gained market share in a declining lubricants market. The entry of new original equipment manufacturers (OEMs) offering new technology vehicles will provide additional opportunities for the company’s products. Lube consumption is projected to grow strongly in cars, fourstroke bikes, as well as building and construction equipment segments.

Gradual growth in personal mobility, as well as corresponding growth in demand for automotive services, are positive factors for the company in the long term. Castrol seeks revenue and value growth through higher dependence on superior technology products relevant to new generation of vehicles, as well as focus on volume growth in the key growth sectors which it has identified. Rather than a broad volume growth strategy, the company is looking at building on profitability.

FINANCIALS:

The company’s balance sheet size has only doubled in the past one-and-a-half decades, while its topline has quadrupled. This shows that the business is not capital-intensive and is earning high returns. The company’s return on capital employed (RoCE) for CY07 stood at 80%. Like a typical multinational company, Castrol adopts conservative financing by being debtfree and distributing the bulk of its profits in the form of dividends.

The company’s net sales have witnessed a compound annual growth rate (CAGR) of 10.8% over the fiveyear period ended December ’07 to Rs 1,966 crore. Its net profit has recorded a lower CAGR of 7.4% to Rs 218.4 crore. At an average payout of 85% of its profits, the company’s dividend payout has broadly grown in line with the corresponding growth in profit during the past five years.

Castrol posted a smart recovery in its operating and net profit margins in ’07. This was fuelled by certain factors like price hikes, exit from low-margin segments that have been commoditised, new product launches, and re-launch of old products with new identity, packaging and strong consumer propositions.

Rising crude oil prices have been a concern for the company since the past two years as oil is a critical raw material for lubricants. However, the company is expected to benefit from the recent crash in crude prices.

CONCERNS:

The growth in use of longer drain lubricants, especially in the commercial vehicle segment, is expected to significantly reduce consumption of lubricant per vehicle. This is expected to reduce volume growth significantly over the next 3-5 years.

Price undercutting by low-cost competitors in an attempt to gain volume share is another threat for this premium-category lubricant manufacturer. A long-drawn slump in the automobile segment may hamper future volume growth of the company’s products. Curtail in infrastructure spend due to the general economic slowdown is also likely to curb the market for lubricants. With an industrial slowdown, the company’s business in the non-automotive segment may also take a hit.

VALUATIONS:

Castrol’s current price-earnings (P/E) multiple is 13.7. This is fairly in line with the 12.8% growth in profit registered by the company over a period of 15 years. The stock is fairly valued at current multiples. Besides, a high dividend yield, stable business and sound financials make the stock an attractive pick for the long term.