Smooth Sail For Mercator

PENNY WISE

The Mumbai-based Mercator Lines is making waves at the bourses. The scrip, which was ruling at a lowly Rs 21.05 on November 20, 2002, has appreciated by nearly 800 per cent to close at Rs 188.60 exactly a year later.

Even allowing for the sustained upside in equity markets for the major part of this year, the stock is a standout.

While a couple of orders, from Indian Oil Corporation (IOC) and Mangalore Refinery and Petrochemicals Ltd (MRPL) were mainly responsible for the surge in the share price of the company, analysts now point out the robust fundamentals of the company.

Incorporated in 1983, Mercator Lines is mainly engaged in coastal and inland water transportation. The company has registered a rapid growth in the past few years and currently has a total of 1,82,311 mt of tonnage capacity.

Mercator's improving financials and the prospects of explosive growth in the next few years are firing sentiments at the counter, say analysts. It has also been paying regular dividends from the time of listing in FY94.

The company has two main divisions - lighterage and shipping. While the shipping division is engaged in the national and international movement of petroleum products and other liquid cargo, the lighterage division operates mainly at Mumbai port.

While the Indian promoters hold 48.50 per cent in the company, public holdings stand at 42.30 per cent and corporate holdings at 9.10 per cent.

For the quarter ended September 30, 2003, Mercator Lines posted an over 800 per cent rise in net profit to Rs 8.40 crore as compared to Rs 0.89 crore during the same period last year.

Its net sales during the period jumped 193.50 per cent to Rs 53.18 crore against Rs 18.13 crore during the previous year.

So what has caused this quantum leap in the company's fortunes? According to analysts, the substantial order book position of the company is one of the major reasons for the solid performance.

Recently, Mercator Lines bagged two major contracts from IOC and MRPL. The contract with IOC is for transporting crude on a time-charter basis.

Mercator Lines had offered its two tankers at $17,770 and $16,310 per day respectively. This contract is expected to bring in Rs 57 crore on a yearly basis for the company.

The company also has a contract worth Rs 100 crore with MRPL, which is to be completed by March 31, 2004.

"Mercator has adopted a de-risked model of acquiring ships and locking them into back-to-back time/voyage charter contracts with domestic oil majors. Its contracts with MRPL and IOC would form the base cash flows from which Mercator can build the future through further acquisitions," says Desai.

The company also acquired three Aframax crude carriers this year. According to Desai, this will not just physically augment its tonnage but grow its revenues and profits manifold in the next two years.

"Mercator's balance sheet size will grow commensurately because its growth has been funded by debt initially. Since it has been fortunate to benefit from high tanker rates and low acquisition costs, its payback on the three ships is expected to be not more than three years. As a result, the company's debt servicing would be excellent. Its acquisitions have been financed by 10.40 per cent secured non-convertible debentures (NCDs), aggregating Rs 9.20 crore approximately, on a private placement basis with UTI Bank, which have been rated by CARE as AA-, affirming high quality investment grade by all standards," notes Desai.

But there is a worry on increasing costs due to acquisitions. "Interest and depreciation costs add up depending on the expansion in fleet size and means of funding. In Mercator's case, since the acquisitions were debt-funded, the interest and depreciation charges (which shot up partly in FY03) will see a marked jump in line with the rise in revenues," says Desai.

However, he is confidant that management will look at options to lower the cost of debt through an ECB or any other route it deems fit.

There is also hope in the shipping industry that the government may replace income tax with tonnage tax during the winter session of parliament. This is expected to improve the financials of shipping companies.

According to one estimate, shipping companies incurred an effective average tax of 10-14 per cent of pre-tax profits. The introduction of tonnage tax is likely to reduce the tax liability to 2 per cent. As for Mercator, this is likely to result in a 14 per cent increase in FY04 post-tax profits.

However, there are other concerns. The average age of Mercators' three Aframax crude carriers and the product tanker is 19 years. Based on International Maritime Organisation norms, the average residual life of the tankers is seven years.

Analysts are concerned that with the older ships, the time span to recover investments and make good returns is compromised, leading to higher financial risk.

According to Desai, another worry is that Mercator's contract with MRPL is due to be completed by the end of FY04. Since that contract will be re-tendered then, Mercator faces the risk of not winning it again in the worst-case scenario.

"Since that contract involves deployment of three ships, of which only one is self-owned, in the event of the contract not being extended on similar terms, Mercator would see a sharp drop in turnover on account of the loss of revenue from the two in-chartered ships. However, it would still be in a position to charter out its owned vessel at the same rates immediately on which there would be no loss of profit. The loss of profit would be on the in-chartered component of the two ships, which could lead to a maximum downgrade of 15 per cent in net earnings," says Desai.

Even after the stock's outperformance, Desai is of the view that there is still plenty of steam left at the counter.

"The stock's recent sharp rise should not be a dampener for investors because the size of Mercator's operations and balance-sheet themselves are slated to rise more than four-fold and profits by eight times in the next two years," he says. The stock currently trades at a P/E of 3.1x.

"It trades at 1x price to book value with a projected RoE of 57 per cent in FY05E. For want of a better yardstick, we believe that a P/E of 5x forward earnings, for a company which will quadruple in size and earn over 50 per cent RoE over two years and beyond, should be a conservative and achievable valuation in a year's time," notes Desai.

According to one analyst, the scrip is cheap compared to its peers like Shipping Corporation of India and Great Eastern Shipping Corporation, trading at 9.5x and 7.6x respectively on FY04E estimates.

"Based on the sustainability of earnings the scrip is due for a re-rating," he says.