Empty vessel

PENNY WISE

Varun Industries operates in a competitive commodity industry and its margins are poor.

Market pundits always tell investors to keep away from low-margin businesses, especially companies that do not have an established brand name and scale. If the company operates in an industry, which is highly competitive and products are commoditised, it's even worse.

These companies are even more vulnerable if they have higher exposure to export income due to unfavourable equation between the dollar and rupee. Varun Industries is the perfect example of such a company.

With over 90 per cent of its income from exports, India's largest exporter of stainless and houseware products, Varun is coming out with a Rs 54 crore IPO.

The company exports over 1,500 varieties of kitchenware, houseware, tableware, cutlery and other items of different types. It acts as a trading company outsourcing all its products from 80 domestic suppliers. The company is highly dependent on third parties and susceptible to any increase in commodity prices.

However, to reduce its dependence on suppliers, it has recently developed an in-house manufacturing facility for stainless steel products at Vasai near Mumbai and also set up a re-rolling mill at Jodhpur, Rajasthan for stainless steel sheets to be used for its Vasai plant.

This plant has an annual capacity of 36,000 tonnes. Even at 40 per cent utilisation in the first year, it will only produce 24 per cent of its current requirement leaving 76 per cent to be still outsourced.

Even later, this capacity is not going to be sufficient for captive sales.

For its expansion, Varun has raised additional debt "� from Rs 205 crore in FY06 to Rs 374.33 crore in July 2007. These projects worth Rs 84 crore have been funded through a mix of debt and internal accruals.

Even after the IPO, its debt-equity ratio will be high at two times. This will also result in higher interest, which has gone up from Rs 11.93 crore in FY06 to Rs 12 crore for four months ending July 2007. Interest cost is almost 50 per cent of the profit before interest and tax, and the company appears highly leveraged.

A majority of this debt is also due to the high working capital needs in the business, and that is also the reason for the IPO. Varun estimated a working capital requirement of Rs 416.88 crore, which is very high compared with its FY07 revenues of Rs 760.78 crore. From the Rs 54 crore issue, the company intends to fund Rs 40.47 crore towards working capital.

Besides working capital requirement, the company will invest about Rs 10 crore for brand building in the domestic market as it expects higher revenues and better margins.

To further diversify, it is also entering into other businesses such as wind power, iron ore mining and oil drilling and extraction. However, all these businesses will require time, money and managerial capabilities.

There is a silver lining of sustained revenue and net profit growth in the past. Its total income and net profit has grown at 51.53 per cent and 34.85 per cent annually over the last four years.

But its operating and net profit margins of 8.42 per cent and 2.62 per cent respectively are not exciting, if we deduct the export incentives from the total income the net margins will be worse at about 1 per cent. With such low margins, any adverse movement in the rupee can erode profitability, or lose its cost advantage against other countries.

The company through its IPO at Rs 60 per share is looking for a market cap of Rs 132.6 crore. On a fully diluted post issue capital, the issue is priced at 6.68 times its FY07 and 5.5 times FY08 estimated earnings.

Though the company may grow from here and manage to succeed, there are a number of risks inherent with its business model. This is also supported by the fact that the IPO has been given a one on five grading by Crisil indicating 'poor fundamentals'.

Issue opens: 25 October
Issue closes: 31 October