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Paper Products: Margin pressure!

Nov 9, 2006

Performance summary
India’s leading manufacturer of primary consumer packaging and labelling materials, Paper Products Limited (PPL), announced results for the third quarter ended September 2006 last week. While net sales grew by 27% YoY, the operating margins fell by 290 basis points due to higher raw material costs. Including the extraordinary item the bottomline has grown by 148.6% YoY. However, if one were to exclude the same, bottomline nosedives by a dismal 56% YoY.

Rs (m) 3QCY05 3QCY06 %Change 9mCY05 9mCY06 %Change
Net Sales 1,042 1,323 27.0% 3,178 3,740 17.7%
Expenditure 898 1,179 31.3% 2,778 3,316 19.4%
Operating Profit (EBDIT) 144 145 0.6% 400 424 6.1%
Operating Profit Margin (%) 13.8% 10.9%   12.6% 11.3%  
Other Income 18 16 -7.4% 62 73 18.2%
Interest 1 1 0.0% 3 4 8.8%
Depreciation 62 57 -7.1% 188 172 -8.6%
Profit before Tax 99 102 4.0% 270 322 19.0%
Extraordinary item (8) 135   (8) 135  
Tax 24 74 202.5% 70 132 88.3%
Profit after Tax 66 164 148.6% 192 324 69.0%
Net profit margin (%) 6.3% 12.4%   6.0% 8.7%  
No. of Shares (m) 12.5 12.5   12.5 12.5  
Diluted earnings per share* (x)         32.7  
P/E ratio (x)         11.5  
(*trailing 12 months)

What is the company’s business?
Paper Products Limited (PPL) is India’s leading manufacturer of primary consumer packaging and labelling materials. The company has a history of over seven decades in the packaging field and its product folio includes flexible packaging, labelling technologies and specialised cartons. It has three fully integrated manufacturing units at Thane, Silvassa and Hyderabad. The company’s client list includes HLL, Nestle, Cadbury, Britannia, Glaxo SmithKline, Coca Cola, Perfetti, Dabur, Marico and P&G. Exports constitute around 14% of total revenues and the company’s international division services large multinationals like Nestle, Unilever, Cadbury and Colgate Palmolive across four continents. In 1999, PPL became a subsidiary of Huhtamaki, a global leader in consumer packaging, which holds a 59% stake in the company. Huhtamaki is headquartered in Finland and is one of the top 10 consumer packaging companies in the world.

What has driven performance in 3QCY06?
Consumption benefits: The robust demand for FMCG products benefited the company’s topline, which reported a growth of 27% YoY. The company is the largest organised player with a market share of 45% of the consumer-packaging segment. It must be noted that PPL is not easily dispensable by FMCG players, as packaging plays an important role in not only creating a visual appeal, but is also important for retaining the quality of the product. Continued focus on the company's innovation program NASP "New Applications Structures and Products & Processes" helped to achieve better sales.

Cost break-up
As a % of net sales 3QCY05 3QCY06 9mCY05 9mCY06
Total Cost of goods 67.0% 69.8% 69.3% 69.1%
Staff Cost 7.6% 7.8% 7.4% 7.7%
Other Expenditure 11.5% 11.4% 10.8% 11.9%

Margins under pressure: The company's raw materials are derived from downstream petrochemical products, which are in turn dependent on crude prices. In 3QCY06, the company witnessed a sharp rise in prices and customers refused to absorb a significant proportion of the rise, thus suppressing PPL's margins. PPL’s raw material costs as a percentage of sales jumped to 69.8%, an increase of 280 basis points over the level of the corresponding quarter in the previous year. With crude prices being volatile and showing little signs of easing below the US$ 60 mark, going forward, the company might continue to face margin pressure.

Extraordinary effect: The company reported a 149% YoY growth in bottomline for the quarter. However, this was on account of an extraordinary income pertaining to the sale of land and the settlement claim amount on account of the July floods. Without considering this extra-ordinary income, the bottomline falls by 56% YoY. This could be attributed lower operating margins, lower other income and higher tax outgo.

What to expect?
At the current price of Rs 376, the stock is trading at a price to earnings multiple of 11.5 times its trailing 12-month earnings and 17 times earnings if one were to exclude the extraordinary income. With commercial production of its new production facility in North India (at a cost of Rs 650 m) expected to start by the end of this year its packaging portfolio will improve. Also with the performance of FMCG sector expected to remain robust, the topline performance of PPL is expected to be strong. We continue to be positive on the stock although pressure on the raw material cost front might lead to near term hiccups.

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