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Apr 12, 2012 05:20 PM IST | Source: CNBC-TV18

PNGRB order to make it hard for IGL to operate: Violet Arch

Sanju Verma, MD & CEO, Violet Arch Capital Advisors feels that PNGRB's order to cut tariffs will make it difficult for IGL to operate

In the wake of the Petroleum & Natural Gas Regulatory Board’s order to Indraprastha Gas (IGL) to cut prices of piped cooking gas and automobile CNG and to refund excess amount charged from consumers since 2008, Sanju Verma, MD & CEO, Violet Arch Capital Advisors feels that the order will make it difficult for IGL to operate. According to her, it would be difficult for the company to implement tariff cut with retrospective effect.

In the commodity space, Verma recommends India Cements while she advises investors to stay away from Tata Steel. In the banking universe, Verma prefers ICICI Bank to HDFC Bank, while she picks Allahabad Bank in the midcap space. Within the PSU banking names, she considers SBI a favourite and believes that this is one stock which will outperform going forward.

Below is an edited trasncript of her interview with Udayan Mukherjee and Mitali Mukherjee. Also watch the accompanying video.

Q: What did you make of the recent developments on the entire gas sector? How would you approach names like IGL etc?

A: We have still not heard the last on IGL. Even if one were to assume what the government is saying is effected by way of bringing down IGL’s network tariffs by 60% down, it is telling IGL that instead of charging Rs 6-7 as gross margins per standard cubic meter, you can charge to your customers Rs 3.4 whereas the operating expenses of IGL alone are something like Rs 2.4 to Rs 2.5.

So my point is A] it becomes difficult for IGL to operate because you are in a business to make money, not to make losses. B] if one were to do as per the government dictat of effecting this with retrospective effect; in the last three-four years since 2008, IGL has been paying out corporate taxes, it has been paying out dividends to its shareholders based on the profits that it made. So, is it practically feasible to even implement with retrospective effect a 60% reduction in compressed margins and network tariffs?

Will the government refund back the excess corporate profits that IGL paid out to the IT authorities? Does IGL have ‘locus standi’ to take back the dividend that is paid out to its shareholders based on a certain profitability number? So I don’t think it is easy.

Analysts have been saying that if the government mandate is affected then IGL FY12 networth, which stood at something like Rs 1,200-1,300 crore gets fully eroded because IGL will have to pay back to the government with retrospective effect something to the tune of Rs 1,500-1,600 crore. But I think the story does not end there because IGL may end up receiving refund from the government on the excess corporate taxes and the dividends that it paid out based on a certain profitability number.

Q: It has been quite volatile over the last few days, flows have become quite anemic. In the near-term, can you see more upside or downside?

A: I have assurance from the fact that yesterday while the Nifty violated the crucial level of 5,200, it recovered, as long as Nifty stays above its 200 DMA, being 5135, we are pretty much home and there is not reason to worry. But that is of course the technical viewpoint.

Fundamentally speaking, I think there has been a huge gyration. Last year, we were all talking about policy inertia and policy paralysis. I think we have kickstarted this calendar year with tremendous amount of policy activism. So my sense is that there has to be a semblance of sanity and balance from being absolutely in a state of inertia to introducing activist measures, the overreaching powers of the judiciary.

The fractious relationship between the executive and the judiciary; not to mention this entire negative hype about general anti-avoidance rule (GAAR), unless we come out of the woods on this front, things will be slightly choppy. But my personal sense is that results will surprise for Q4 of FY12. While topline growth may not be 25-26% like in the last few quarters, it will settle down at more pedestrian levels of 18-19%.

I think the earnings growth for the Sensex companies should be in the region of 10-11%. While stocks like Reliance and Tata Steel may disappoint in a big way, you will see huge positive surprises coming in from SBI, Tata Motors; a part of that could be because of the base effects playing out. But core defensives like FMCG, pharmaceuticals, some of the private sector banking stocks, even some of the stocks within the auto space may surprise on the positive. So I think earnings should give the much needed kicker.

If policy activism is reined in, I think that should be a positive. My personal sense is that it is good that we had this GAAR mess because finally it is time to take a call whether we need participatory notes at all in the first place. In 2007, P-Notes accounted for close to 40% of FII flows in India whereas in the last two-three years, P-Notes account for just about 15-17% of FII flows. So for just about 15-17% of FII flows, which together are something like USD 200 billion, why this entire brouhaha?

We just need to take a call that we do not need the P-note structure at all. If you have to invest in India, you have to be a full-fledged registered FII. But yes, the government needs to clarify that on the debt front, FIIs will not have to pay withholding tax. Remember, the USD 20 billion has come into the country in the last few months in G-Sec alone from FII, that limit has been breached, a little less than USD 20 billion.

If the FIIs have to pay capital gains tax and also withholding tax of 20% and you are buying a ten year bond at 8.6 or 8.7, effectively the net return is just about 7% or so, which is less than the repo rate of 8.5%. So I think that is the big clarification. It is not so much on the equities front, but the debt flows have got knocked big time. FIIs have sold USD 1.5 billion worth of debt in March after buying government debt consecutively all the way from September of 2011, it is only in March that they sold. So I think the big confusion and the worry is on the debt flows, and not equity flows. Equity flows will take care of themselves.

Q: How are you approaching banks now?

A: Our big house-view at this point of time is to sell HDFC Bank and buy ICICI Bank. It is a switch and even a sell on standalone basis. The reason for a sell on HDFC Bank, which is a big call, is that in the last one year, the net interest income growth, which is one of the best parameters to measure, how efficiently a bank is run and how well the core income is growing, has halved 25% one year back to just about 12% for Q3 of FY12.

I think in Q4 of FY12, it will stay in the region of 12-13%. Why would anybody want to pay close to four times price to book for a bank where the NII or the core income is growing at just about 12%? We are telling investors not to get carried away by this 30% net profit growth, which HDFC Bank has been showing every quarter for the last 20-30 quarters.

On the core income front, things have tapered off big time. Hence, paying premium valuations is certainly not justified. Most importantly, I think valuations of four times price to book were being paid to HDFC Bank because of its sheer conservatism. But I think they have thrown conservatism out of the window. Now, the retail portfolio, which accounts for more than 50% of their total loan book, is growing at around 28-29%. This is scary whereas the wholesale portfolio that is growing at just about 13-14% accounts for less and half of their loan book.

If you are a conservative bank, which is commanding premium valuations, it is the wholesale loan book which should be growing. The retail loan book should not grow and the unsecured portfolio should grow in single digit. But it is exactly the opposite, which is happening - that is my concern.

In the last two quarters, the 30% growth in net profit shown by HDFC Bank has come at the expense of lower provisioning. Provisioning for the last two quarters consecutively is down more than 28-29%. So they have been dipping into the provisioning pool to pad up numbers. I think that is not a very pleasant scenario.

The big call is sell HDFC Bank, buy ICICI Bank. Within the smaller banks, we like Allahabad Bank, which is trading at less than one time price to book, return on equity of more than 12%, business growth of 17-18%. Of course, the CASA is not very flattering; that is the only negative. Otherwise, this is one bank within the midcap space, which has consistently been showing an NII growth of more than 20% and profit growth of more than 30%.

Within the PSU banking space, we continue to like SBI and believe that this is one stock, which will outperform going forward.

Q: You spoke about Reliance and Tata Steel which should report poor numbers this time. Generally, global commodities have done quite badly and have underperformed the market. How would you approach these names?

A: Tata Steel, at a consolidated level, the numbers are far from flattering and that is putting it very mildly. They did an EPS of around Rs 99 in FY11. My metals analyst tells me that the FY12 EPS will barely be something like Rs 44-45, though in FY13, that obviously scales up all the way to Rs 55-56.

Optimistically speaking, they could even do a Rs 60 EPS in FY13. But between FY11 and FY13, the CAGR growth has virtually been zilch. From Rs 100 EPS in FY11 to assuming in an optimistic scenario an EPS of Rs 60 in FY13 is not saying too much about the company - this, when realizations are actually not bad.

If you look at a player like SAIL, for instance, despite a 20% increase in production year-on-year in the third quarter of FY12, SAIL actually managed to show a realization growth of 18% year-on-year. The EBITDA per tonne went up 28% quarter-on-quarter and 10% year-on-year. Needless to say, the reason I am talking of SAIL is one stock that we have got bang on target with respect to coverage. We initiated coverage at about Rs 72. The stock currently is at about Rs 92 or thereabouts. We have a price target of Rs 94, which obviously has been breached at various points in the last two to three months.

We continue to believe that this is one stock within the metal space, which will outperform. Our bull case price target actually is a pretty aggressive Rs 136, which I think, will be achieved. SAIL clearly stands to benefit if the recent price hikes of 7-8% in the last three months is anything to go by. They have had three price hikes in the last three to four months. My sense is that you really can’t go wrong with the stock, which is trading at 9 times price-to-earnings.

I would stay away from Tata Steel. If I have to really look at another metals name then perhaps I would look India Cements. Cement companies have had phenomenal run-up in the last five to six months for no good reason because volume growth was hardly there. They will end FY12 with hardly a 6.5% volume growth. In FY13, cement companies will do a volume growth of 9-10% is the general consensus.

But the reason for liking India Cement is that they are likely to do something like Rs 9-10 EPS this year and about Rs 13 next year. So there is earnings comfort and this is one stock which is trading at a huge discount. I don’t think you can go wrong buying it at about 9 times one year forward. From the broader commodity space, India Cement, SAIL, in a limited sense, Hindalco as well.

Q: Any thoughts on the market interest around IVRCL and the potential bidding over there?

A: We have still not seen the end of all that has been happening in the IVRCL counter. IVRCL is fully valued at around Rs 70-75, which is what the price has been in the last few trading sessions. My personal sense is at a price of Rs 70, IVRCL’s market cap works out to something like Rs 1,900 crore whereas the book value of this company is something like Rs 1,980 crore. So it is trading at a small discount to its book value. But that is not the reason I believe that the stock will go up to Rs 90 or Rs 95 or Rs 100.

The bidding power obviously will help IVRCL shareholders and it makes sense to stay put. But I think what not many analysts are taking note of is the fact that IVRCL has a 55% stake in Hind Dorr-Oliver; that stake is valued at close to Rs 210 crore.

IVRCL also has a 75% stake in another listed entity called IVRCL Assets. That 76% stake is valued at roughly Rs 850 crore. The stand-alone IVRCL is around Rs 920 crore in terms of market capitalization. If you add these stakes in Hindustan Dorr-Oliver and IVRCL Assets, the total market cap in a consolidated sense for IVRCL along with its other holdings works out to Rs 3,000 crore. So even if the stock price runs up to Rs 90, the market capitalization will be only about Rs 2,400 crore, which would still be lower than the actual value of IVRCL and its stakes in various listed entities.

So the potential will be capped only after the stock hits Rs 90-100 or thereabouts for the sheer reason that it’s trading at a steep discount to its market cap in a consolidated sense. But the big takeaway is that any company where the promoter holding is just about 25% or even lower and the free float is large, need to be worried. I think three large companies, which come to my mind, where the promoter holding is just 25% are Mahindra and Mahindra, Dr. Reddy’s and Grasim. These are three large well known diversified conglomerates where institutional shareholding is more than 30-40% but the promoter holding is just about nudging 25%.

The lesson is that these are potential takeover candidates at some point of time unless the promoters really get their act together. IVRCL, of course, cannot be compared to an M&M or a Dr. Reddy’s because IVRCL has a net debt-to-equity of something like 1.6 times. But I think this is a huge takeaway also for many other people who believe that order book is everything.

For a company like IVRCL with a market cap of Rs 1,900 crore, they have an order book of Rs 25,000 crore. Order inflow of last year was Rs 12,000 crore. So if you have to just go by the order pipeline, this is a great story. But the execution was not happening. The cash was not coming. Working capital situation was pretty much bad. They were strapped for cash and that’s the reason that Sudhir Reddy’s 11% stake really didn’t help him and became an ideal candidate for a potential takeover. While minority shareholders will gain, it’s a wake-up call to investors who go just by order book and start grabbing infrastructure companies.

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