Reduce Finolex Industries: Edelweiss

Edelweiss report on Finolex Industries:

In Q1FY08, Finolex Industries reported net profit of Rs 245 million up 158% Y-o-Y and 40% Q-o-Q, on account of better regional PVC margins. We have increased our FY08 EPS by 6% to Rs 6.4/share to factor in the strong PVC margins (Q1FY08). We have however downgraded our FY09 EPS by 7% to INR 8.0/share numbers to incorporate higher employee expenses and lower operating margins. Going forward, we expect moderation in PVC margins from current levels. At CMP of Rs 87, the stock trades at 13.7x and 10.9X our FY08 and FY09 EPS estimates of Rs 6.4 per share and Rs 8.0 per share respectively. On an EV/EBITDA basis, the stock trades at 8.9x our FY08 estimates. Even after adjusting for land sale realisation of Rs 3.5 billion and market value of investments in Finolex Cables, the stock trades at 5.9x our FY08 estimates, which we believe, is full valuation for a nonintegrated petrochemical manufacturer. We continue to maintain our 'REDUCE’ recommendation on the stock, but expect positive movement over the short term after the land sale is announced.

PVC resin volume down 15% Y-o-Y and 6% Q-o-Q

PVC resin sales was lower at 34,000 MT compared with 36,219 MT in Q4FY07 and 40,000 MT in 1FY07, as difficulty in procuring VCM (key input for the new PVC plant) continued. The company’s long-term contracts for VCM supply are likely to be effective only September 2007 onwards. Until then, the resin sales are estimated to be subdued. Despite increasing realisations, net revenues were down 9% Q-o-Q to Rs 2.8 billion due to lower PVC
resin volumes.

Gross profit up, led by improvement in regional margins

Gross profit increased 15% Y-o-Y and 25% Q-o-Q to Rs 713 million with improvement in gross profit margins to 25.5% from 18.6% in Q4FY07 on the back of increased PVC margins. The PVC margins, in turn, were higher due to softer ethylene and EDC prices. PVC resin realisations increased 15% Y-o-Y and PVC pipe realisations increased by 10% Y-o-Y, in line with global trends (USD 959/MT in Q1FY08 compared with USD 835/MT in Q1FY07).

Land deal to be announced soon

The company has indicated finalisation of land sale worth Rs 3.5 billion and is expected to make a public announcement of the same by this month end. The cash flow from this sale is expected to accrue only after six months, after the company hands over its Pune premises to the buyer. We expect this land sale to be a positive for the company, since it would help it reduce net debt.

Other quarterly highlights:

Employee expenses were up 46% Y-o-Y and 57% Q-o-Q, as the wages increased 35- 40%.

Interest expenses were lower 89% Y-o-Y and 72% Q-o-Q to Rs 10 million, in spite of debt level of Rs 4.8 billion (similar to debt level in the previous quarter), due to favourable movement in their interest rate derivatives.

Reported other income was at Rs 351 million, including Rs 258 million of exchange gain in procurement of raw materials that we have included in raw material costs.

EPS estimates revision - Maintain ‘REDUCE’

We have increased our FY08 EPS by 6% to Rs 6.4 per share to factor in the strong PVC margins (Q1FY08). We have however downgraded our FY09 EPS by 7% to Rs 8.0 per share numbers to incorporate higher employee expenses and lower operating margins. Going forward, we expect moderation in PVC margins from current levels. At CMP of Rs 87, the stock trades at 13.7x and 10.9X our FY08 and FY09 EPS estimates of Rs 6.4 per share and Rs 8.0 per share respectively. On an EV/EBITDA basis, the stock trades at 8.9x our FY08 estimates. Even after adjusting for land sale realisation of Rs 3.5 billion and market value of investments in Finolex Cables, the stock trades at 5.9x our FY08 estimates, which we believe, is full valuation for a non-integrated petrochemical manufacturer. We continue to maintain our 'REDUCE’ recommendation on the stock, but expect positive movement over the short term after the land sale is announced.

Investment Theme

The Government of India’s (GOI) thrust on irrigation, micro-irrigation, water, and housing projects is expected to drive demand for PVC pipes and fittings that account for more than 57% of the total PVC consumption in India. Finolex Industries is well-placed to benefit from this opportunity directly and through its venture with Plastro and Plasson for drip irrigation projects. The demand for PVC in India is expected to grow at 10% CAGR in the next decade, as the per capita consumption of PVC in India is around 0.8 kg compared with the world average of 4.6 kgs. In spite of the robust demand outlook, we believe that supply of PVC from China could affect PVC margins in India going forward. Also we believe that given the non-integrated nature of the business the earnings is too leveraged to PVC prices and hence at on EV/EBITDA of 5.8X FY08 we believe the stock is fairly valued.