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SCI: Good times, ahoy!

Nov 19, 2004

Performance summary
The rise in commodity and crude prices may be a bad news for the global economy. But it has been a dream run for shipping companies, globally and in India, over the last eight quarters. The performance of Shipping Corporation of India (SCI) reflects the underlying strength in freight rates and the resultant improvement in profitability.

(Rs m) 2QFY04 2QFY05 Change 1HFY04 1HFY05 Change
Net sales 6,910 7,726 11.8% 14,282 15,594 9.2%
Expenditure 5,228 5,190 -0.7% 10,113 9,941 -1.7%
Operating profit (EBDITA) 1,682 2,536 50.8% 4,169 5,652 35.6%
EBDITA margin (%) 24.3% 32.8% 29.2% 36.2%
Other income 62 274 339.4% 115 1,355 1083.3%
Interest (net) 88 24 -72.5% 138 22 -84.4%
Depreciation 690 725 5.0% 1,377 1,509 9.6%
Profit before tax 965 2,061 113.5% 2,768 5,476 97.8%
Extraordinary income/(expense) - - - - - -
Tax 165 (40) - 402 190 -52.8%
Profit after tax/(loss) 801 2,101 162.5% 2,366 5,286 123.4%
Net profit margin (%) 11.6% 27.2% 16.6% 33.9%
No. of shares (m) 282.3 282.3 282.3 282.3
Diluted earnings per share (Rs)* 11.3 29.8 16.8 37.5
Price to earnings ratio (x) 4.7
(* annualised)

What has driven performance in 2QFY05?
Freight rates have hardened: As is evident from the graph below, freight rates of the tanker segment continue to show improvement on a quarterly basis on the back of strong demand for oil from emerging markets like China and inventory build-up by select developed nations like the USA. While SCI has virtually no presence in the VLCC segment (very large crude carriers), the fact that Aframax and Suezmax rates have also hardened has helped matters for SCI in 2QFY05. Suezmax and Aframax freight rates have risen by 127% YoY and 63% YoY in 2QFY05. With a fleet of 27 oil tanker vessels, SCI has reaped the benefit of the same. While the softening of crude prices in the recent past is likely to lower freight rates, we expect the robustness to continue in 2HFY05 as well.

Source: GE Shipping

Margins take a leap: Since shipping is a high fixed-cost business, whenever there is a sharp rise in revenues, with fixed cost remaining the same, margins tend to expand significantly during periods of favorable freight rates. The rise in operating margins in 2QFY05 has to be viewed in this context. Having said that, SCI's operating margin at 33% in 2QFY05 pales in comparison with GE Shipping (48% in 2QFY05). One of the key reasons for the same is the company's presence in the liner segment (passenger and container transportation), which is a low margin business. Secondly, almost 59% of the tankers of SCI are single-hull, which command lower premium in the global waters.

Segmental margins...
% margin 2QFY04 2QFY05 1HFY04 1HFY05
Liner 2.6% 5.5% 4.3% 2.9%
Bulk 16.4% 27.1% 22.5% 36.6%
Others 89.1% 110.8% 84.3% 102.2%
PBIT margin 16.6% 28.2% 21.4% 34.2%

The graph aside indicates the EBDITA margin (earnings before depreciation, interest and tax) trend over the last six years. While we expect margins to improve further in 2HFY05, the sustainability of the same remains to be seen. Shipping is a highly cyclical business and freight rates are influenced not only by demand but also the country of demand (if more demand arises out of US, the time taken to transport crude is longer from the source of crude and to that extent, the capacity is blocked. Without getting into the complexities, it is referred to as tonne-mile demand in the shipping industry). Visibility in revenues beyond a six months period is poor.

Higher other income boosts net profits: While other income has risen sharply in 2QFY05 and in 1HFY05, the reason for the same is not clear. Even after excluding this item from both the quarters, net profit has increased by 147% in 2QFY05. This indicates the underlying strength in freight rates.

What to expect?
The stock currently trades at Rs 176 implying a price to earnings multiple of 4.7 times annualised 1HFY05 earnings. The company's venture into LNG transportation, typically contracted for around 20 years, is a big positive. Besides, SCI is also expanding its tanker fleet and replacing its single-hull vessels (59% of crude vessels). Though these are positive for the stock, the fact that the downside risk to freight rates is higher now increases the risk profile of the stock. Besides, we do not expect the underperformance of SCI in relation to GE Shipping to change in the future, given the PSU status and regulations.

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