Buy BHEL; target of Rs 1650: Merrill Lynch


Merrill Lynch has recommended buy rating on Bharat Heavy Electricals, BHEL with price objective of Rs 1650. The stock currently trades at 19x FY09E PER vs BSE Sensex at 15x.

Merrill Lynch report on BHEL:

What If BHEL acquires Bharat Heavy Plates & Bharat Pumps?

News agencies have reported that BHEL may acquire & turnaround 2 weak units under its ministry namely, Bharat Heavy Plate & Vessels (BHPV) & Bharat Pumps & Compressors (BPCL). We analyze the likely impact should these companies be merged with BHEL. We believe the merger would not have a material financial impact on BHEL given:

* BHPV and BPCL’s combined sales in FY07E was 1.8% that of BHEL while their combined losses before tax of Rs 113 million was 0.3% of BHEL’s PBT;
* Their workforce of ~2400 people in FY06 was 5.6% that of BHEL’s and
* Apparently, BHEL would invest Rs 200 million (0.3% of its net cash) in BPCL vs ONGC’s investment at Rs 1 billion, as per news reports.

BHPV & BPCL merger strategic; but cautious if these recur

Strategically, as BHEL has a business fit with both these companies, it should be able to turn around these acquisitions and hence, could be positive. Also, if these mergers are a one-off case of weak PSUs to be merged with a profitable one, then it should be fine, especially as the size of their size / losses are not material for BHEL. However, if this were to become a trend, we would become more worried as BHEL’s ministry, Department of Heavy Industries (DHI), oversees many companies with significant losses.

Reiterate Buy on improving pipeline and competitiveness

We expect BHEL stock to outperform as it address key concerns on Chinese competition, super-critical orders (likely in FY08) and improve competitiveness through operating leverage - 67% capacity expansion with <10% rise in labor.

Bharat Heavy Plate & Vessels Ltd. (BHPV)

BHPV was set up in 1966 to cater to the requirement of equipments for core sectors such as fertilizers, oil refineries, petrochemicals, etc. The company has three product divisions namely; Process Plant Division, Cryogenics and Boiler Division. The company has been making losses for last few years and is now being reviewed in the light of Public Sector Policy under National Common Minimum Programme (NCMP). The company is likely to have production of Rs 1.75 billion in FY07.

Bharat Pumps & Compressors (BPCL)

BPCL was incorporated in 1970 to cater to the requirement of various sectors such oil, fertilizer, chemicals etc. for the supply of various types of pumps & compressors. The company subsequently became sick and was referred to the Board for Industrial & Financial Reconstruction (BIFR). BPCL was reviewed in the light of Public Sector Policy under National Common Minimum Programme (NCMP) and a restructuring plan for the company has been approved by the Government. The company is likely to have production of Rs 1.35 billion in FY07.

Bloated Workforce – Key reason for underperformance

The key problem with BHPV and BPCL seems to be their bloated work force. Employee expenses accounted 58% of sales for BHPV and 44% for BPCL in FY04. Although this ratio has been brought down to 16% for BHPV and 24% for BPCL in FY07E, we note that the employee expense in absolute terms has infact increased by 12% CAGR for BHPV and 15% for BPCL over FY04-07E. We believe that recovery of capex in the target markets and the takeover by a relatively efficient player such as BHEL, which already has complimentary products related to BHPV and BPCL, could revive these companies.

Price Objective Basis & Risk

Our Price Objective of Rs 1650 is based on FY09E PER of 22x – 10% discount to peak PE in the last cycle (94-97). BHEL currently trades at 19x FY09E PER vs BSE Sensex at 15x. However, we believe, that premium valuation is justified given BHEL’s superior market position, earnings growth and RoE.



Buy Godrej Consumer; target of Rs 174: Angel

GCPL has significantly underperformed the broader indices over the past several months due to margin pressures. However, we estimate GCPL to witness stability in margins owing to better product mix, recent price hikes and higher fiscal benefits. At current levels, GCPL is a strong value play in the FMCG space with superior return ratios, steady earnings growth and a dividend yield of 3%.

In Soaps, clear strategy to grow through marketshare gains:

Soaps accounted for 51% of the branded sales and 29% of PBIT (consolidated) during FY2007. Innovative launches coupled with strong promotional support and suitable price points have helped GCPL consistently meet its target of gaining 100bp marketshare every year. We expect GCPL’s Soaps division to grow at a CAGR of 19.6% over FY2007-09E.

Huge potential to be unlocked in Toiletries segment:

Toiletries is expected to remain one of the key growth drivers for GCPL. Better product mix, higher promotional expenses, innovative launches in existing and new segments along with higher contribution of Keyline brands and SCA Hygiene JV are expected to drive growth in this category. We expect the category to grow at a CAGR of 37.5% (standalone) and 18% (consolidated) over FY2007-09E.

Inorganic growth strategy to boost growth:

GCPL has adopted the inorganic route to boost growth with a major focus on the Personal Care segment. Synergies in GCPL’s domestic business model and international operations will be the key driving force for growth in Keyline and Rapidol. We expect Keyline and Rapidol to account for 15.5% and 4.8% of topline and 11.3% and 3.7% of PBIT respectively, at the consolidated level, for FY2009E.

Valuation

We expect GCPL’s revenues to grow at a CAGR of 18.6% to Rs1,340cr and earnings to grow at a CAGR of 19% to Rs190cr over FY2007-09E. We have used the DCF methodology to value the company. Our Target Price based on FY2009E numbers works out to Rs 174 at which the stock would trade at 20.7x Earnings and 16.3x EV/EBITDA. We initiate coverage on GCPL with a Buy recommendation.




Accumulate Nucleus Software: Edelweiss

Increased focus on product business to enhance EBITDA margins

Since inception, Nucleus Software Exports (Nucleus) has focused on the BFSI vertical. With 250+ product implementations, for its flagship product - FinnOne™ - Nucleus has credibly positioned itself as a retail banking packaged software player. As on FY07, 54% of its revenues came from the product segment, which is expected to grow at a CAGR of 64.5% over FY07-09E, contributing 72.6% to total revenues in FY09E. This is likely to result in EBITDA margins expanding from 28.61% in FY07 to 29.9% in FY09E.

ACOM deal – another marquee client on the list

Nucleus has recently won the Rs 1.5 billion ACOM (Japan) deal (1x FY06 revenues), taking its total order book to Rs 3.3 billion (as on FY07). ACOM being one of Japan’s largest consumer finance companies establishes strong franchise for Nucleus. For this deal, Nucleus competed with several companies with strong forte in the BFSI segment. This builds on top of the multi-site execution that Nucleus is engaged in for GMAC. We thus believe that the deal puts Nucleus head-on with companies in the BFSI segment globally.

Industry Overview

BFSI segment – multiple growth drivers exist

Over the past decade, the BFSI segment has become increasingly dependent on information technology (IT). IT spending, BFSI’s top priority, is being increasingly directed towards addressing the long-standing issues related to core applications, including achievement of higher operational efficiency, better risk management, regulatory compliance, and enhanced customer satisfaction. Also, with the advent of globalisation, all the global banks are standardising their core systems across multiple countries. These institutions are increasingly looking for complete solutions for business expansion and achievement of cost effectiveness. Gartner estimates demand for BFSI product development industry to grow at 25-30% over the next 3-5 years on the back of multiple growth drivers. This represents huge growth opportunities for companies this segment.

Global retail assets base – a huge market waiting to be addressed

Datamonitor estimates the global retail assets base worth USD 26 trillion (as on 2005) to grow at a 6% CAGR till 2010, to USD 32.5 tn. Of the USD 26 trillion of retail assets, almost 50% comes from the US and 80% are mortgage assets. Nucleus estimates that it services USD 60-65 billion retails assets currently, which represents a quarter percentage of the global retail asset base. We believe this represents huge growth opportunity for Nucleus and other retail-focused players.

Company Overview

Business segments

Products – In the products segment, Nucleus is totally focused on the BFSI vertical with an IPR-led strategy for a global presence. While offering a full range of products on both assets and liability components of the business to its clients, Nucleus has achieved significant presence in the retail loans segment. Product revenue for Nucleus comprises license fees, revenues from customisation and implementation of products, and technical support.

FinnOne™

FinnOne™, Nucleus’ flagship product, is an integrated suite of applications designed to support the typical business offerings of banks and financial solutions companies. Till date, the company has implemented 250+ modules in 22 countries. Originally built on Oracle platform, FinnOne™ is now available on Java J2EE platform. FinnOne™ currently contributes 95% to Nucleus’ total product revenues .

Other products

Nucleus’ other products in cash management, internet banking, fraud management, and credit card segments are Cash@will™, BankONet, FMS, and PowerCard (a distributed product), respectively. During Q307, the company received an order from a large European bank, to implement Cash@will™ in over 16 countries. During FY07, the aforementioned products contributed 54% to Nucleus’ total revenues, up from 38% during FY06. Going forward, Nucleus plans to introduce more products in BFSI segment, thereby reducing its dependence on one product. We expect revenues from this division to grow at 64.5% CAGR over FY07-09E, contributing 72.6% to the total revenues in FY09E. Projects and services – On the project and services front, Nucleus provides technology and implementation consulting, customised software development and support, and services related to testing and network maintenance. Nucleus has two major clients in Japan and Singapore, which contribute 94% to project revenues. Going forward, Nucleus plans to look for opportunities with large international banks. During FY07, projects contributed 40% to Nucleus’ total revenues, whereas services contributed a meager 6.1%. We expect revenues from project and services divisions to grow at 10% and 7.9% CAGR over FY07-09E, contributing 24 % and 3.3% to the total revenues in FY09E, respectively.

GMAC deal - a big break-through

GMAC is one of the world's largest auto finance companies with businesses such as automotive finance, commercial and residential mortgages, and insurance. During September 2004, Nucleus won an order worth USD 12 million from GMAC to roll out the loan servicing and collection management modules of FinnOne™ at its international locations across 37 countries in Asia Pacific, Europe, and Latin America. Spread over a four-year period (beginning 2005), this is the biggest rollout in the banking space by any Indian company abroad. Nucleus had already implemented the FinnOne™ modules for GMAC in India and several other Asian locations like Taiwan, Indonesia, Thailand, and China over a period of four years before this deal. The GMAC deal has taken contribution from Europe to 11% of total revenues in FY06 from 5% in FY05. Moreover, the GMAC order has opened up avenues for further penetration in the European and US markets. The GMAC deal, involving the multi-site implementation of its flagship product, has been a strong reference point to bid for business from other retail lending institutions globally. During October 2004, Nucleus acquired 25.1% strategic stake in GMAC Financial Services India Ltd (the Indian automotive finance operation of GMAC) for Rs 136.8 million; the remaining 74.9% stake is with GMAC, earlier subsidiary of General Motors. This indicates the company’s commitment to built long-term relationships with its clients.

ACOM deal – another feather in the cap

During January 2007, Nucleus bagged another big deal worth Rs 1.5 billion, surpassing the GMAC deal from ACOM Co. Ltd (ACOM), the second largest consumer finance company in Japan. Nucleus was working on this deal from the past three and half years and would be replacing certain IBM systems in this assignment. The deal involves implementation of FinnOne™ and PowerCARD, and offshore development service offering from India over next two years, followed by technical support for five years from India. Revenues from this deal have started flowing from Q4FY07 onwards. The project would go live by Q1FY09 with 100-200 people working on the deal at any point of time. The scope of the project involves end-to-end IT transformation of ACOM’s consumer finance operations across all its branches and networks. We believe that order demonstrates Nucleus’ capability of winning big orders in the future and gives it significant revenue visibility over the next two years.

Client concentration across various geographies

Nucleus currently has clients across 22 countries. As on FY07, top five clients contributed 63% to revenues. The graph below shows the revenue concentration over the past four years in various geographies.

Strategic initiatives

Change in the license fee structure in the offing Historically, Nucleus charged a one-time license fee, which is a function of number of countries/sites, and number of users. In the developed markets, the trend is however charging license fees per transaction on a per account basis. Nucleus has made a beginning in this direction recently and for two new customers (apart from the upfront license fee) they have built-in additional fees based on the size of portfolio. Initially, the license fee for Nucleus used to be around 40% of the order value, which it claims to be currently in the range of 50-60%. Huge cash and investments – building a warchest for acquisition As on FY07, Nucleus has cash and investments to the tune of Rs 819 million which are expected to go up to Rs 1.5 billion by FY09E.We believe that the company is preparing itself for acquisitions going ahead. Capacity expansion - on the cards Nucleus has five development centers globally, with state-of-the-art development center at its five acre campus at Noida. The other centers include Singapore, Delhi, Chennai, and Pune. During the second phase of development at Noida, Nucleus has added 800 seats by FY07 end, at a cost of Rs 160 million; it will add another 800 seats in the third phase by the end of FY08 at Rs 200 million respectively. Besides this, the company is also looking at buying another piece of land by FY08E end, at an estimated cost of Rs 200-400 million. The entire expansion would be funded through internal accruals. Nucleus has 1532 employees (globally including the subsidiaries) as on FY07, of which 1305 people are in the technical department. There is core team of 160+ people out of 1305, dedicated for product development and product management. We estimate Nucleus to add 460 people in FY08E and 310 in FY09E, taking its total employee strength to 2289 in FY09E. Continued investments in new product development and upgrades Nucleus intends to invest 10% of its total revenues in R&D every year, towards new product development and upgrading the existing products suite. During FY07, Nucleus has launched a new product module in FinnOne™, “FinnForecaster”, which is a decision driver for predictive analysis and data modeling. By June 2007, a new product release for Cash@will™ is scheduled. This commitment augurs well for sustainable future growth of the company.

Outlook

Nucleus operates among the fastest growing segments of the product development industry that has a huge addressable market, along with multiple growth drivers. Further, it is also one of the most challenging segments to be in, as the product acceptance takes a longer time. This is evident from the fact that the Nucleus had been working on the ACOM deal for almost three and half years. Given Nucleus’ strong focus in the BFSI vertical, high pedigree management, strong client list and excellent return ratios, its prospects appear bright. However, we believe that the stock appears fairly priced at current levels and further upsides to estimates are possible as and when Nucleus bags new orders. We expect Nucleus’ revenues and profits to grow at 42% and 41% CAGR, respectively, between FY07 and FY09E. At the CMP of Rs 991, the stock trades at 21x FY08E EPS of Rs 47 and 14.5x FY09E EPS of Rs 68.1. We thus initiate coverage with an ‘ACCUMULATE’ recommendation.




ML maintains buy on Cadila Healthcare; target of Rs 425

Strategic acquisition in Brazil; Maintain Buy

Acquisition of Brazilian company Nikkho- a reasonable deal

Cadila has signed an agreement to acquire 100% stake in a mid-sized Brazilian company Quimica e Farmaceutica Nikkho do Brasil Ltda. (Nikkho) for US$26mn, which values the deal at 1x sales (CY06) and less than 8x EV/EBITDA multiple. We view this deal as strategic since it enables Cadila to strengthen its position in the fast-growing US$1.2bn Brazilian generics market.

Key highlights from the deal

Consolidates presence in the high-growth Brazilian generics market (25% CAGR)

Access to branded generics portfolio of 22 marketed products and 50 registrations in niche therapies like gynecology, neurology & respiratory

Access to local manufacturing capacities in injectibles and liquids

Expected to be EPS accretive from second year of acquisition

Likely 5-7% EPS accretive in FY09E

Nikkho had annual sales of USD 26 million (CY06) with EBITDA margins of ~13-14% and we estimate current net margins of around 5-7%. Taking into account Cadila’s aggressive expansion plans in Brazil, we estimate the deal to be EPS neutral in FY08E and 5-7% EPS accretive in FY09E.

Maintain Buy with robust business outlook

Maintain Buy with a PO of Rs 425 per share. Valuation is attractive at 17.8x FY08E and 15x FY09E EPS, which are at 11% and 20% discounts to the sector average.