Punj Lloyd: Hard times

Potential losses are worrying the Street as are possible margin pressures.

The auditors of Punj Lloyd, have mentioned, in the notes to the accounts, that the company has not provided for potential losses of Rs 300 crore (£37 million) from one of the contracts being executed by Simon Carves, a company acquired by Punj Lloyd.

Had the losses been taken into account, the engineering firm's pre-tax profit of Rs 483 crore would have been lower to that extent.

The amount is significant which is why the stock has come off by about 13 per cent since Friday. The management believes that the cost increases have happened because of changes in the design and scope of the work.

It has clarified that it has reached a settlement for about 15mn pounds and is negotiating for the rest and should be able to break even. The Street, however, remains worried.

Meanwhile, the Street was quite happy with the increase in revenues for the March 2008 quarter at 38 per cent as also the 51 per cent growth in FY08 revenues, to Rs 7,753 crore.

The better than expected increase in the operating profit margin for FY08, which was up 100 basis points at 8.3 per cent, was driven more by the stand-alone operations and mainly the result of better operating leverage with staff costs in particular coming off.

On the other hand, margins for the international subsidiaries, which contribute about 60 per cent to total revenues, have been weak falling by over 250 basis points to 3.9 per cent.

While, this should change as most of the low-margin contracts have been executed, margins for the Indian operations may remain flat.

That's because although the current order book is healthy at Rs 19,600 crore and amounts to approximately 2.5 times FY08 sales, the share of the higher margin Indian orders has fallen.

That together with higher raw material costs, especially that of steel which has risen by 30 per cent in the last four months, could keep operating margins under pressure this year ""at best margins will remain at current levels.

Industry watchers say that unlike other bigger players in the engineering and construction space, Punj Lloyd may not be able to pass on the higher costs by re-pricing all contracts which were entered into when steel prices were lower.

The company is expected to close FY09 with revenues of over Rs 9,700 crore and a net profit of close to Rs 400 crore. At Rs 281, the stock trades at 22 times estimated FY09 earnings and is a tad expensive given that profitability could be strained.

Sterlite: Refining the business

Should Sterlite Industries manage to complete the buyout of the US-based Asarco, a copper mining, smelting and refining company, it would help de-risk the metals firm's business. The company's various businesses will now contribute more evenly to the ebitda (earnings before interest, depreciation and tax).

Analysts estimate that the contribution of zinc to Sterlite's consolidated ebitda, which is now nearly 45 per cent and this could come down to 31 per cent in a couple of years. In turn, the contribution of copper, which now accounts for 17 per cent, will chip in with a much larger share of over 40 over cent.

The Rs 24, 705 crore Sterlite has acquired the bankrupt Asarco for $ 2.6 billion in cash, valuing it at four times 2007 EV/ ebitda and given the high quality of assets that it is buying, the deal is not expensive. Asarco's mines have an estimated 5 million tonnes of copper reserves.

The company may borrow some amount to fund the deal but will mainly use the cash reserves that it already has "" the group has about $3.8 billion in cash and cash equivalents. A dilution of the equity capital appears unlikely at this juncture.

Asarco reported revenues of $1.9 billion for CY2007 and operating profit of $ 640 million. This is not the first time Sterlite is taking over an ailing company and like in the past it should be able to bring down costs and expand capacity which should improve profitability.

Moreover, the outlook on copper prices remains promising over the medium term. As such, analysts reckon that the acquisition could chip in with about Rs 15 per share to Sterlite's estimated earnings per share for FY10 of Rs 83-84.

The current spot LME price of copper is around $ 7979 per tonne, though prices could taper of somewhat. Should Asarco be able to charge some premium for higher margin finished products like copper cathode and cathode rods, the profitability would improve further.

In CY07, the miner sold 235, 000 tonnes of copper. At Rs 902, Sterlite trades at around 14 times estimated FY 09 earnings Hindalco at Rs 184 trades trades at 16.3 times estimated consolidated FY 09 earnings.