Investor's Eye: Update - United Phosphorus, Information Technology, Oil & Gas

 

Investor's Eye [June 28, 2013]  Sharekhan www.sharekhan.com

Summary of Contents     STOCK UPDATE United Phosphorus Recommendation: Buy Price target: Rs180 Current market price: Rs136 Annual report review  Key points Latin American and North American markets are key revenue drivers, domestic market remains dull: The 20% growth in the revenues of United Phosphorous Ltd (UPL) in FY2013 was mainly driven by the good performance of the North American and Brazilian markets. In FY2013 the Brazilian business' first year of full operations was marked by a strong agriculture season and a robust revenue growth. Second, the company had a focused strategy to maximise the output from the most profitable units which helped in rationalising the costs. UPL has maintained its 50% market share in wheat herbicides by launching seven products in the last four years. The company successfully launched a new insecticide (Ulala) and a new fungicide (Atabron) during the year.  Focus on premium products cushioned margin: In a major shift in its focus, the company has started to lay more emphasis on premium products in order to maintain its margin and minimise the operational risk from the commodity agro-chemical products. Apart from the acquisition-driven strong growth in the Rest of World, the company also reported a double-digit growth in both North America and Europe. The healthy growth also translated into an improvement in the operating profit margin (OPM), which stood 200 basis points higher at 19% as compared with the previous year's margin. Exports during the year accounted for 56% of the total sales.  Better resource management improves operating cash flow: The operating cash flow improved significantly during FY2013 on the back of better resource management. The debtor days and inventory days declined by 7 days and 3 days respectively while creditor days increased by 13 days, thereby improving the working capital cycle of the company. The working capital days decreased by 24 days to 89 days in FY2013. During the year the company generated operating cash of Rs1,699 crore, which was significantly higher than the previous year's. Debt/equity ratio goes up in FY2013: The debt/equity ratio increased sharply from 0.37x in FY2012 to 0.51x in FY2013 on account of a decline in the net worth (UPL bought back shares worth of Rs223.5 crore in FY2013) and an increase in the long-term debt. As on March 31, 2013 the net debt position stood at Rs2,655 crore, an increases of Rs100 crore as compared with that on March 31, 2012.  Return ratios remain constant along with a steady dividend pay-out: In FY2013 the company's return ratios remained stable at the level of FY2012 on account of a good operating performance (on the back of better sales volume from Brazil due to the acquisition of DVA Agro) by most geographies except India. The return on equity (RoE) stood at 16.7% while the return on capital employed (RoCE) stood at 15.3% during the year. The dividend pay-out ratio of the company stood at 14.3% in FY2013. With better earnings visibility for the coming years, we expect UPL's dividend pay-out ratio to remain healthy going ahead.  Management comments on outlook: The company's management believes that going ahead the revenue growth will be driven by the company's ability to generate more cash through manufacture of its low-cost, high-quality products that are present in 90% of the world's agro-chemical markets. The management is aiming for a double-digit growth in the coming year and will maintain the EBIDTA margin at the current level. The company expects to reinforce investments in research and development, which will strengthen the process and product pipeline, translating into better margins and RoCE. Further, the company expects to improve its working capital cycle by controlling inventory and debtors.  Valuation: We expect the top line and the bottom line of UPL to grow at a compounded annual growth rate of 10% and 11.3% respectively over the next two years. This growth will be achieved on the back of a good operating performance by most of the geographies including DVA Agro in Brazil. At the current market price the UPL stock trades at 6.5x FY2014 and 6.1x FY2015 estimated earnings. We maintain our Buy rating on the stock with a price target of Rs180.   SECTOR UPDATE Information Technology  Tussle between boon and bane, imperative to remain selective The CNX IT Index' performance (2.5% return) has remained muted despite a depreciation of close to 9% in the rupee against the dollar in the last one month. This reflects the ongoing tussle between a boon and a bane in the information technology (IT) sector. On the boon side, the rupee's depreciation is acting as an earnings tail wind. On the other hand, policy overhang (the US immigration bill) coupled with weak performance indicators (soft numbers from Oracle and Accenture) raises the fear that demand may not be predictable anymore for the sector. The US immigration bill in its current form will be a structural disruption for the sector and have a potentially damaging impact on the earnings of the IT companies. Though the depreciating rupee is a boon for the sector, but given the cyclical nature of the tail wind, the weaker rupee will not be able to outweigh the structural head wind of the impending US immigration bill. Overall, we remain selective on IT stocks rather than taking a secular call on the sector. In terms of earnings predictability and management delivery execution, we remain positive on Tata Consultancy Services (TCS) and HCL Technologies (HCL Tech) among the large-cap companies and we like CMC and Persistent Systems in the mid-cap space.  US immigration bill, a structural head wind for the sector: The US immigration bill in its current form has the potential to disrupt the current business landscape of the Indian IT sector. Recently, the US Senate passed the bill, which will now go to the House of Representatives by July 2013. The House of Representatives will either discuss the bill in its present form or draft a new bill altogether after which a vote will be held on the bill. Finally, it will go the President for his final approval (the whole process will take six to eight months). The bill in its current form is severely damaging for the Indian IT sector. Though we hope that the most severe outplacement clause in the current version of the senate bill will get diluted in the final bill, but even without the outplacement clause the impact of the bill on the margin of the IT companies will be felt to the extent of 100-200 basis points, led by a higher visa cost, a higher wage cost and a higher cost of hiring locals (would affect the onsite utilisation).  Weak numbers from Oracle and Accenture indicate weak discretionary spending: The recently announced weak numbers from Accenture and Oracle have put a question mark on the demand predictability for the sector. This is the second consecutive quarter of weak numbers from both Oracle and Accenture. For the Q4FY2013 quarter Oracle has reported a mere 2% growth in the new licence sales on a constant-currency basis (the lower end of the guidance of 1-11%) and guided for a 1-9% year-on-year (Y-o-Y) growth for Q1FY2014. Accenture's consulting revenues dropped by 2.5% year on year (YoY) and new order booking was down 3.7% YoY (the latter is a lead indicator of discretionary spending). On the other hand, Accenture's outsourcing revenues grew by 4.5% YoY and 0.8% quarter on quarter (QoQ; the last quarter's growth was 9.4% YoY) in Q4FY2013. Commentary from both the management teams points to a deferral of clients' decisions and slowdown in the pace of spending.  Rupee's depreciation, cyclical tail wind: The rupee has depreciated by close to 36% in the last two years and by 9% in the last one month. Recently it even crossed the 60 mark against the dollar. Traditionally, for every 1% fall in the rupee the earnings before interest and tax (EBIT) margin of an IT company improved by 30-40 basis points. However, in the last seven quarters the rupee has depreciated by 16% whereas the EBIT margin of the top four domestic IT companies except HCL Tech has not shown any improvement. The currency gains are not reflecting as margin gains perhaps because IT companies are ploughing the currency gains back into business to strengthen their front-end (where the sales and marketing cost is higher). Among the large-cap companies, HCL Tech has shown the highest margin improvement with a 558-basis-point expansion over the period from September 2011 to March 2013. The margins of TCS and Wipro have remained stable whereas Infosys has reported the highest margin decline of 461 basis points. Going forward, we may not see all the benefits of the rupee's depreciation translating into a secular improvement in the margin across the sector. However, the weakness in the local currency will continue to act as a margin tail wind for the sector and help the IT companies to re-invest their currency gains into business and strengthen their front-end to gain market share. On the flip side, if the rupee stays above the 60 level in the coming quarters, then the IT companies will have to readjust their current hedging strategy to negate the potential hedging losses.  Valuation: We remain confident of the earnings predictability of our preferred IT picks. However, the US immigration bill will have a negative impact on the margin profile of these companies. At the current juncture, given the overhang of the US immigration bill and the continuous softness in the discretionary spending environment, it's become imperative to remain selective on IT stocks rather than taking a secular call on the sector. In terms of earnings predictability and management delivery execution, we remain positive on TCS and HCL Tech among the large-cap companies and like CMC and Persistent Systems from the mid-cap space.      Oil & Gas  Gas price hike approved; RIL key beneficiary Key points  Cabinet approved Rangarajan gas pricing policy; revised gas price is $8.4/mmbtu The Cabinet Committee on Economic Affairs (CCEA) approved the proposal to hike the gas price to $8.4/mmbtu from $4.2/mmbtu at present for a period of five years beginning April 2014 (not yet published officially). The gas price hike is in line with recommendation of the Rangarajan Committee. The Rangarajan Committee's formula uses long-term and spot liquid gas (liquefied natural gas [LNG]) import contracts as well as international trading benchmarks to arrive at a competitive price for India. Further, the revised gas price of $8.4/mmbtu will be reviewed every quarter and will apply to all the gas producers uniformly including state-owned firms like Oil India Limited (OIL) and Oil & Natural Gas Corporation (ONGC), and private companies like Reliance Industries Ltd (RIL). The government will also earn higher revenues as the profit/revenue share from producers. But benefits to PSU upstream companies is unclear Logically, the move to double the gas prices augurs well for the upstream companies like ONGC, OIL and RIL in terms of (a) better realisation, (b) an improvement in profitability and (c) a likely increase in the production level through revival of few gas fields, which was not viable at $4.2/mmbtu. However, the past experience shows that the government would not leave all the benefits on the books of the public sector undertakings (PSUs; higher subsidy burden as put on ONGC/OIL after the last price hike of gas from $2.4/mmbtu to $4.2/mmbtu). Thus, we see scope for rerating of only RIL and a limited impact on PSU upstream companies till clarity emerges on the subsidy and royalty front. GAIL's management expects compensation for negative impact of gas price hike; OIL could be the casualty According to comments by the management of GAIL, it would be compensated by the government for the adverse impact of gas price hike on its petrochemical (petchem) business by way of lower subsidy burden. In such a scenario, the additional subsidy burden (increased fertiliser subsidy) could be put on OIL, which is a huge beneficiary of the hike in the gas prices. Thus, the stock has corrected sharply. However, we believe it is only a knee-jerk reaction and would wait for further details before reviewing our recommendation on the sock. Revised gas price could trigger higher domestic gas production; but only in long run The sizeable gas reserves of India are unviable at a price of $4.2/mmbtu, which would be viable after hike in the gas price and eventually the domestic gas production will improve. Moreover, the higher gas price will attract more investment in the sector. However, we opine that based on the above rational, the gas production could improve in the country but only in the long run. Click here to read report: Investor's Eye   Sharekhan Limited, its analyst or dependant(s) of the analyst might be holding or having a position in the companies mentioned in the article.

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