Welspun Gujarat (WGSR) reported a spectacular 163.5% yoy rise in net profit for Q1FY08—while revenues were in-line with our estimates, a sharp expansion in margins led to profits significantly better than our estimates. Operating margins for the quarter expanded to 16.6% (USD 237/tonne) representing a 370bps expansion in operating margins on a sequential basis. The jump in operating margins was primarily due to profitable orders from the likes of Kinder Morgan and Exxon Mobil and appears to be sustainable atleast over the next 2 quarters. WGSR has added orders worth USD 634 million during the quarter, taking the total outstanding order book position to USD 1.1 billion (1.6x FY07 revenues). Management confirmed that the plate mill project is on track with likely commissioning in Dec’07. We have upgraded our EPS estimates for FY08 and FY09 by 18% and 37% respectively, to factor in higher margins. Maintain Outperformer.

Profit jumps 164% to Rs 693 million; operating margins surprises

WGSR reported a 50%yoy growth in revenues primarily led by execution of its order book position in SAW pipe business. LSAW pipes contributed 46% of sales volumes, followed by 42% and 12% for spiral and ERW pipes respectively. Revenues continued to be largely led by exports with a contribution of 90%. Average realization for the quarter at USD 1424/tonne—registered a sharp 23% growth. Operating margins for the quarter expanded to 16.6% (USD 237/tonne)—highest ever for the company, representing a 370bps expansion in operating margins on a sequential basis. The jump in operating margins was primarily due to profitable orders from the likes of Kinder Morgan and Exxon Mobil and appears to be sustainable atleast over the next 2 quarters. Lead by sharp expansion in operating margins, net profit for the company was much higher than our estimates at Rs 693 million.

Order book swells to Rs 45 billion

WGSR’ book position as on June, 2007 stands at robust Rs 45 billion to be executed over next four quarters with Spiral & LSAW contributing 55% and 40% respectively. Robust order book at Rs 45 billion (1.6x FY07 revenues) provides clear visibility for potential future stream of cash inflows. WGSR has now emerged as one of the key suppliers to global O&G majors like British Gas, Exxon Mobil, Shell. More importantly, we believe WGSR has managed to gain a strong foothold in USA (60% of its order book position), the most stringent market, which speaks volumes about its quality standards and cost competitiveness. A strong client base in the US would also help the company in scaling up its upcoming manufacturing unit in US.

Plate mill nearing completion – to provide strong margin kicker

WGSR’s 1.5m tonne plate mill project for backward integration is on schedule for commissioning in Dec’2007. To put things into perspective, WGSR currently imports more than three-fourth of its raw material from Europe and the CIS countries. There is an acute shortage of pipe grade plates and hence availability of raw material is a key risk. To offset this, WSGR is in the process of setting up a plate-cum-coil mill in Anjar, Gujarat (near its SAW pipe facilities). The project, at an estimated cost outlay of Rs 18 billion, is scheduled to be operational by December 2007. We expect a very sharp expansion in operating margins with the commissioning of the plate mill project on the back of resultant savings in raw material and freight costs. We also expect significant reduction in working capital for the company once the backward integration project is commissioned. Our numbers for the plate mill however, currently assume a conservative conversion margin (slab to plate) of only USD 100/tonne—against current margin trend in excess of USD 230/tonne. We believe that there can be significant upside risk to our numbers if current conversion margins were to sustain at current levels.

US manufacturing unit

WGSR had earlier announced 60:40 joint venture with Lone Star Technologies, Inc for a HSAW pipes project in the US. The project plan was a capture a pie of the fast growing US market for large diameter HSAW pipes. The project planned a 300,000 tonnes capacity with an investment of USD 100 million. However, Lone Star Techologies recently was taken over by US Steel Inc, which opted out of the JV. WGSR consequently bought over the 40% stake now held by US Steel for a consideration of USD 2 million and has already commissioned construction work on the site. Management guided that the facility would be ready for production by Sept’08 and is likely to be funded through a mix of debt and equity (80:20).

Maintain Out performer

A strong expansion in margins for WGSR lends credence to our macro call - in terms of strong demand for pipes on the back of infrastructure spending and increasing acceptance of domestic vendors in the international market. Increasing vendor approvals, strong order book position and continued strength in crude oil prices we believe would help in sustaining a strong demand momentum. With strong client approvals, we believe WGSR is extremely well positioned to tap a burgeoning opportunity—a strong order book position (USD 1.1 billion) offers growth visibility. Commissioning of the plate project is likely to be another key trigger for the stock price. We maintain our OUTPERFORMER rating on the stock with a price target of Rs 285 per share—based on our adjusted DCF methodology.