Irrational valuations

The stocks of Anil Ambani's companies have soared too much

The companies under the control of the newly formed Anil Dhirubhai Ambani Enterprises, Reliance Energy and Reliance Capital saw their market value increase by 11.1 per cent and 24.9 per cent, respectively, on Monday.

The gain in the market value of Reliance Industries, on the other hand, was a much more sedate five per cent. True, Reliance Industries' market cap, at Rs 87,850 crore is much higher and requires much more funds to drive the stock.

Reliance Energy, in comparison, is much smaller at Rs 12,200 crore and Reliance Capital is even smaller with a market cap of less than Rs 4,000 crore.

But what about IPCL, which has a market cap of around Rs 4,200 crore and has risen by less than 4 per cent?

Also, one of the main reasons given by market experts for the increase in the share price of Reliance Capital is that the value of its holdings in Reliance group companies has increased.

But the cumulative value of its holdings in Reliance Industries and Reliance Energy has risen by less than Rs 120 crore, much lower than the Rs 740 crore increase in Reliance Capital's market cap on Monday.

It's interesting to note that the Reliance Capital stock has now risen by over 110 per cent since news of the ownership dispute became public.

For an investment company, it now trades at an absurdly high PE of 35 times FY05 earnings.

Clearly, the Anil group's stocks are rising on the basis of the announcements made about pumping in new money into Reliance Energy and Reliance Capital.

However, no time frame has been fixed for the investment. Nor is it at all certain whether this money will automatically lead to a high RoE.

The financial services sector, for instance, is extremely competitive.

While Reliance Capital seems to be an extreme case, even Reliance Energy looks expensive. It trades at over 25 times diluted FY05 earnings, despite the fact that earnings growth prospects aren't bright in the near future.

Other income accounted for nearly 80 per cent of FY05's profit before tax and analysts believe that last year's other income was driven by non-recurring items and would drop substantially this fiscal.

Besides, new projects already confirmed by the company are not expected to drive earnings before FY09. What's more, Reliance Energy has raised huge funds, and financial assets now account for around 60 per cent of the company's total assets.

As a result, its return on capital employed was only about 7 per cent last year. Of course, in the medium term, there could be upsides from the power generation projects planned at Dadri and Uttaranchal.

Besides, growth could come from winning tenders from state electricity boards, who are expected to gradually privatise distribution.

The main business for Anil Dhirubhai Ambani Enterprises, in terms of both annual revenues and assets, is the telecom business.

Lately, because of the uncertainty about the ownership and other regulatory issues, month-on-month subscriber growth fell to about 3-4 per cent compared to around 6 per cent in the early part of last fiscal.

The company also voluntarily discontinued services for around a million subscribers in the March quarter of FY05 to tackle defaults.

Analysts expect growth to pick up now that the uncertainty is over. But that'll be easier said than done, since the company will now operate under a new top management.

Besides, Reliance Infocomm faces the double whammy of a high fixed cost base and a lower-than-peers ARPU. Its margins and profit, therefore, are expected to lag that of peers like Bharti in the future.

Matrix Laboratories

Considering that the dust has barely settled on Matrix Laboratories' decision to merge Strides Arcolab with itself, Matrix's announcement that it would be acquiring a controlling stake in Belgium based Docpharma NV came as a surprise.

The Belgian and neighbouring pharma markets offer large growth opportunities, with generics constituting barely 4-5 per cent of the approximately $4 billion market, but analysts believe that the acquisition has been expensive.

That's because Matrix would spend up to $263 million or about 2.3 times estimated sales of the overseas company for the financial year ended June 2005.

In contrast, Ranbaxy had earlier acquired France-based RPG Aventis for about 1.58 times sales.

Certainly, Matrix would avoid incurring large marketing and legal costs to establish its presence in these Benelux and adjoining countries, but analysts point out that there remains the underlying fear of pricing pressure in the European generics markets too, given the spate of players focusing on these markets.

However, N Prasad, chairman and chief executive officer, Matrix Laboratories pointed out that the Belgian company is expected to grow aggressively in the next 15-18 months and that valuations should be looked at from the perspective of the long term growth opportunities that the Belgian company offers.

Also, a key focus of Matrix management would be on improving operating margins of the Belgian company in order to ensure that this acquisition is substantially earnings accretive in the medium term.

The EBITDA margin for the overseas company in the nine months from June 04 to March 05 was 13.06 per cent, compared to margins of 24 per cent for Matrix in the year ended March 2005.

As a result, it looks increasingly likely that Matrix would need to focus on realising synergies by supplying generic APIs to its Belgian division, both to lower costs in Europe and also expand the product's portfolio.

With contributions from Mobis Philipose and Amriteshwar Mathur