Indo Gulf: Where to from here? - Views on News from Equitymaster

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Indo Gulf: Where to from here?

Feb 8, 2005

Performance summary
The fertilizer stocks have been in demand on the stock markets in the recent past. While investors seem to be enthused by increased focus of the government on agricultural reforms and good monsoons in the calendar year 2004, the performance of one of the most cost efficient producers of urea in the country i.e. Indo Gulf in 3QFY05 reflects the ground reality. While topline grew at a healthy pace, impacted by lower price support and higher cost of packaging materials, operating profit grew marginally during the quarter. For 9mFY05, operating profit has actually fallen by 10% YoY.

(Rs m) 3QFY04 3QFY05 Change 9mFY04 9mFY05 Change
Net sales 1,500 1,737 15.8% 4,069 5,068 24.5%
Expenditure 1,156 1,387 20.0% 3,124 4,213 34.9%
Operating profit (EBDITA) 344 350 1.9% 946 854 -9.6%
EBDITA margin (%) 22.9% 20.2% 23.2% 16.9%
Other income 73 47 -36.0% 248 144 -42.0%
Interest 4 3 -23.8% 12 9 -20.0%
Depreciation 109 101 -6.9% 307 301 -2.0%
Profit before tax 304 293 -3.7% 875 688 -21.4%
Extraordinary income/(expense) - - - - - -
Tax 73 114 56.6% 245 268 9.3%
Profit after tax/(loss) 231 179 -22.7% 630 420 -33.3%
Net profit margin (%) 15.4% 10.3% 15.5% 8.3%
No. of shares (m) 45.1 45.1 45.1 45.1
Diluted earnings per share (Rs)* 20.5 15.8 27.9 18.6
Price to earnings ratio (x) 7.0
(* annualised)

What is the company's business?
Indo Gulf, an Aditya Birla Group Company, has presence in the urea segment with an assessed capacity of 865,000 MT (metric tonne). The manufacturing facility is located in Jagdishpur (Eastern India), which is towards the end of the HBJ gas pipeline of Gas Authority of India Limited (GAIL). Therefore, Indo Gulf has access to gas, which makes its operations relatively cost-effective. The company's presence in the Eastern market is of significance because of the fact that almost 60% of the urea consumption is accounted for by the Northern and Eastern markets.

What has driven performance in 3QFY05?
Capacity utilisation remains healthy: The company produced 242,000 MT of urea during the quarter, which represents a capacity utilisation of 100%. Like we have mentioned before in our analysis with respect to the urea sector, the incentive to produce beyond the 100% capacity utilisation is nullified in the absence of subsidy. Unlike the previous regime wherein urea manufacturers were guaranteed a fixed return on capital employed to the tune of 12%, in the current phase II of de-regulation, urea manufacturers receive a fixed subsidy at 100% capacity utilisation levels. Though production, based on our estimate, is increased by 5%, net sales has grown at a faster rate owing to higher contribution from the branded urea during the quarter. This has been a trend in the last six quarters.

The raw material pressure…
(Rs m) 3QFY04 3QFY05 Change 9mFY04 9mFY05 Change
Change in stock 49 (51) - 69 (69) -
% sales 3.3% -2.9% 1.7% -1.4%
Raw materials 685 938 36.9% 1,793 2,729 52.2%
% sales 45.7% 54.0% 44.1% 53.9%
Power and fuel 186 249 33.7% 519 743 43.2%
% sales 12.4% 14.3% 12.8% 14.7%
Salaries 67 83 23.6% 237 267 12.5%
% sales 4.5% 4.8% 5.8% 5.3%
Other expenses 168 168 -0.2% 506 543 7.3%
% sales 11.2% 9.7% 12.4% 10.7%

Its packaging material this time: As is evident from the table below, there has been sharp rise in raw material and power costs as a percentage of sales during the quarter. The company has attributed the same to the spurt in packaging materials and partly due to higher naphtha prices. At the same time, the company has opined that the availability of natural gas (one of the key feedstock) was relatively better during the quarter, which has enabled it to post higher operating margins as compared to 2QFY05. The company has entered into an gas supply agreement with GAIL in the earlier part of FY05, which seem to be bearing fruit now. This combined with lowering of support prices has resulted in operating margins falling at a much faster rate in 9mFY05.

Higher tax incidence subdues net profits: Though other income during the quarter fell sharply, there was cushion from lower interest and depreciation charges. But higher tax incidence has resulted in net profit declining at a much faster pace of 23% in 3QFY05. As is evident from the graph below, operating margins of the company have been under pressure in the last few quarters in light of higher usage of naphtha and the lowering of subsidy support. But on the back of better gas availability, operating margins in 3QFY05 are higher than 2QFY05.

What to expect?
At Rs 130, the stock is trading at a price to earnings multiple of 7.9 times our FY06 estimated earnings. We have factored in benefit on the raw material cost side in our FY06 assumption taking into account the company's agreement with GAIL and the consequent reduction in naphtha usage. Operating margins will be, in our view, at the 3QFY05 levels in FY06. At the same time, we have factored in the possibility of increase natural gas prices in our assumptions (by around 30%). The benefit of the de-bottlenecking exercise will also start reflecting in the company's performance towards the second half of FY06, which is a trigger to the topline growth and better economies of scale. But taking into the account the highly regulated nature of the industry and slower growth prospects, the risk profile of stocks from this sector is higher. Amidst positives and therefore the consequent upside potential, we continue to maintain our positive view on the stock from a three to five year perspective.

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