Investor's Eye: Thematic Report (Closure of switch call from Indian Oil to Oil India); Update - Orient Paper and Industries (Price target revised to Rs80)

 

Investor's Eye [August 30, 2012]  Sharekhan www.sharekhan.com

Summary of Contents THEMATIC REPORT Closure of switch call from Indian Oil to Oil India  Closing switch call from IOC to OIL with absolute returns of 12%; outperforming Sensex and BSE Oil & Gas Index: Our Switch Idea to shift from Indian Oil Corporation (IOC) to Oil India Ltd (OIL), released on December 15, 2011, has given a positive return of 12% without considering the interim dividend of Rs14 paid to the shareholders by OIL during the above mentioned period. Taking the dividend into account, the absolute returns would be in excess of 15% during the period. The rationale to close the call is driven by the rising uncertainty related to subsidy sharing by the upstream companies on account of the firming up of the crude oil prices. Moreover, the oil marketing companies get a boost from any move by the government to hike the prices of the petroleum products to lower the subsidy burden and the ballooning fiscal deficit. Thus, we believe it would be prudent to take some profits home and are consequently closing the switch call. Oil India Rising crude prices prompt us to close the switch call: The recent surge in the price of crude oil to $112 per barrel in August 2012 from $90 per barrel in July 2012 augurs ill for OIL as it will result in a higher subsidy burden to make up for the losses incurred by the oil marketing companies. The rising uncertainty could result in the underperformance of the OIL stock in the near term.   Notwithstanding the near-term concerns, we maintain our positive stance on the stock: In the exploration and production space we prefer OIL from a long-term perspective due to its huge reserves and healthy reserves replacement ratio, which would provide a reasonably stable revenue growth outlook. Further, the stock's current valuation is at discount to its historical average valuation.   Indian Oil  Likely increase in the price of petroleum products: The prices of regulated petroleum products like diesel, liquefied petroleum gas and kerosene are expected to increase in the near term. This augurs well for the oil marketing companies like IOC, Hindustan Petroleum Corporation and Bharat Petroleum Corporation as it will control the under-recoveries and consequently reduce the working capital requirement of these companies. The decision to increase the petroleum product prices has been long pending and could not be implemented due to political pressure. However, with the recent increase in the price of crude oil, we believe the government would have to take some steps to curtail the fuel subsidy and hike the prices of the retail petroleum products.   Improvement in GRM The gross refining margin (GRM) of the refining companies corrected sharply in Q1FY2013 due to a contraction in the Arab light-heavy price spread, lower product cracks and inventory loss. However, in the past one month the GRM has improved by around $2 per barrel on account of better product cracks (gas oil and gasoline). In addition, the company may see inventory gains because the prices were lower in Q1FY2013. Hence, we believe IOC, which has a refining capacity of 55mtpa, could benefit in the coming quarter.    Orient Paper and Industries Cluster: Vulture's Pick Recommendation: Buy Price target: Rs80 Current market price: Rs71 Price target revised to Rs80  Key points Impressive operating performance in the cement segment more than makes up for weakness in the paper and electrical businesses: In spite of an increased loss in the paper business and margin pressure in the electrical business, Orient Paper and Industries (Orient Paper) delivered an impressive performance in FY2012. The performance was supported by a robust growth in the earnings of the cement business (earnings grew by 61.5% at EBIT level). The net sales and profit of the company grew by 25.8% and 47.9% respectively in FY2012 compared with the FY2011 numbers. The performance of the cement business was well supported by a nearly 30% surge in the blended realisation. On the other hand, the performance of the electrical division was affected (declined by 7.3% at the EBIT level) by margin pressure on account of cost inflation. Further, the paper division continued to disappoint with a loss of Rs61.7 crore at the EBIT level. Overall, the performance of the company during FY2012 was impressive as the robust earnings growth of the cement business was able to offset the negative impact of the weak performance of the electrical and paper divisions.  Investing for growth across business segments: In order to expand its scale of business in the cement division, the company is in the process of setting up a 3-million-tonne-per-annum (mtpa) greenfield capacity in Karnataka. The company has already placed the orders for the plant and the machinery, and the plant is likely to be commissioned in 2014-15. In the paper business, in order to address the water shortage issue the company has set up a 250-mn-gallon water reservoir which will minimise or eliminate the plant shutdowns in future. In addition, the company is in an advanced stage of commissioning a 55MW captive power plant (CPP) for the paper division (the CPP is likely to be commissioned by Q2FY2013) and the same is expected to result in cost savings of about Rs30-35 crore annually. In the electrical division, the company has raised the fan production capacity and increased the focus on lighting products. It has also introduced a range of household electrical appliances which will support the revenue growth of the division in future.  Working capital cycle deteriorates but net operating cash flow remains healthy, leverage at comfortable level: The working capital cycle of the company increased to 59 days in FY2012 from 44 days in FY2011 on account of an increase in the debtor days and a decrease in the creditor days. However, the net operating cash flow (after working capital adjustment) saw a growth of 19% (lower than the earnings growth) to Rs282 crore. The company has a strong balance sheet with a debt/equity (D/E) ratio of just 0.6x and return ratios (return on equity [RoE] and return on capital employed [RoCE]) in the range of 15-20%.  Demerger of cement business to unlock value: The company has incorporated a new subsidiary named Orient Cement. The cement business of Orient Paper will be transferred to newly formed subsidiary. Orient Paper received the approval for the proposed demerger from the High Court of Orissa on July 27, 2012. The demerger of its cement division will come into effect from April 2012. We believe the development is a positive for Orient Paper as it will unlock value for the shareholders through a direct exposure to a pure cement business. However, as per our interaction with the company's management it would take around three to four months to complete the formalities and list the demerged cement business on the bourses.  Outlook and valuation: Orient Paper's performance in FY2012 was largely driven by a healthy growth in its cement business. However, the likely increase in the cement supply locally could pressurise the cement realisation going ahead. On the other hand, we expect the performance of the electrical business to improve on the back of the introduction of new products. Moreover, we are positive about the organisational restructuring that would also unlock value for the shareholders. Hence, we maintain our Buy recommendation on the stock with a revised price target of Rs80. At the current market price, the stock trades at a price/earnings ratio (PER) of 5.6x and EV/ EBIDTA of 3.4x, discounting its FY2014 earnings estimate. Click here to read report: Investor's Eye   Sharekhan Limited, its analyst or dependant(s) of the analyst might be holding or having a postition in the companies mentioned in the article.

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