VSNL: Buy

Investors with a penchant for high risk can consider taking fresh exposure in the Videsh Sanchar Nigam (VSNL) stock with a one-year perspective. At the current market price, the stock trades at a price-earnings multiple of 24 times its likely 2006-07 earnings. While the valuation is not cheap and the fundamentals yet to stabilise fully, there are two near-term potential triggers for the stock.

Impact of listing

One, the proposed listing of Flag Telecom, Reliance Communications subsidiary, at the London Stock Exchange, is likely to have a positive impact on the valuation of Tyco Global Network, the undersea cable network acquired by VSNL. These assets were acquired by VSNL by $130 million in 2005 and its undersea cable capacities are similar to Flag Telecom at 65,000 km.

Going by the preliminary valuation estimates of $1.5-2 billion for Flag Telecom, if the listing happens at this value, it will have a positive effect on VSNL too. Even if we assign a value of 70-80 per cent to the assets of Flag, Tyco's value will work out to Rs 160-175 per share.

Two, according to recent news reports, VSNL has plans to de-merge the telecom business into a separate company. The existing company, which holds the prize-surplus real-estate assets of VSNL, will become the holding company.

This proposal is said to be under government scrutiny. While no confirmation is available, this reflects that the government is possibly moving closer to a decision on monetising the real-estate assets that will unlock handsome gains for shareholders of VSNL.

According to the original privatisation and shareholding agreement, 51 per cent shareholding in the real-estate company was to be held by the government and the rest with the shareholders.

On a per share basis, rough estimates place the real estate value at anywhere between Rs 200 and Rs 240.

Though no moves are afoot now, with the listing of Idea Cellular and Vodafone's acquisition of Hutch-Essar, the Tatas may consider restructuring the entire telecom holding within the group.

If the Tatas decide to consolidate all the assets under Tata Teleservices, the mobile arm of the group, VSNL, which holds an effective equity stake of 14.1 per cent (as of March 31, 2006) in the former will have an opportunity to monetise this equity holding.

The value of this equity stake will be about Rs 75 depending on the valuation placed for Tata Teleservices.

Based on the sum-of-the-parts valuation, elements such as real estate, Tyco and equity stake in Tata Teleservices offer a fair degree of valuation comfort in the stock.

The flip side

On the flip side, however, there are three variables that are a cause for concern. VSNL has recast its business into three broad segments — wholesale voice, carrier and enterprise/carrier data and broadband.

Of these three segments, it is likely to face intense competition in the wholesale voice, which includes the international/domestic long-distance voice operations as newer players enter the fray.

The segment margin on the wholesale voice business has been stable at 17.5 per cent in the first nine months of 2006-07 compared to the corresponding previous period.

Two, any slowdown in enterprise/carrier data is likely to hit them hard as the margins from this segment are spectacular.

Finally, Flag Telecom has approached the Arbitration Tribunal of the International Chamber of Commerce seeking monetary relief of $406 million from VSNL relating to construction and maintenance of Flag Europe-Asia cable system. As it is a legal dispute, its impact of financials is hard to evaluate at this point.

NTPC: Buy

If you are a conservative investor with a low-risk appetite and willing to invest for medium/long-term returns, then NTPC is a stock that you could consider.

Trading in the Rs 130-140 price band for the last few months, the stock broke out last week to touch a high of Rs 160. It has since retraced its steps marginally, and given the thumbs down from the market to the 2006-07 provisional results announced on Thursday, it could fall further in the next few trading sessions.

Investors can use this opportunity to acquire the stock, as the company's prospects appear promising in the medium-term.

The NTPC stock is not for those eyeing short-term returns but for those seeking a defensive play in a volatile market.

Efficient generator

In a sector plagued with efficiency issues, NTPC stands out for its operating efficiencies within the overall limitations of its public sector character. Its coal-based stations achieved a plant load factor (PLF is the measure of capacity utilisation) of 89.43 per cent in 2006-07; the average for the whole country is less than 80 per cent.

Of course, NTPC's PLF would drop if the performance of its gas-based stations were included. But, again, even here, the company has managed to push up the average PLF beyond 75 per cent during the last couple of quarters by sourcing gas in the spot market.

This has enabled the company to recover fixed charges unlike earlier. NTPC sourced spot market gas at prices as high as $10.5-11.5 per million British Thermal Unit (mbtu) during the third quarter to push up PLFs.

Yet, its power cost remained competitive because the quantities were low and when averaged with the much cheaper domestic gas, the overall price was still affordable compared to the cost of naphtha, the alternative fuel, at $22-25 per mbtu.

The experience will stand it in good stead in the next few months when the demand for power shoots up, giving NTPC the chance to run its gas-based stations that have traditionally been idling at low PLFs, at full throttle.

The weighted average cost of NTPC's power rose marginally to Rs 1.73 per unit but it still ranks among the cheapest in the country.

This is a big advantage under the merit order system of power despatch in terms of which the cheapest power is sourced first.

Emerging fuel balance

Coal-based stations have traditionally dominated NTPC's portfolio with a share in excess of 85 per cent of its total generation capacity; gas-based capacity makes up the balance. The downside of total reliance on thermal power came to the fore last year when soaring prices of crude oil and scarcity of natural gas forced the company to idle its gas-based stations while a looming shortage of domestic coal caused a minor scare forcing it to resort to imports.

The fuel mix will undergo a change for the better in the next couple of years when a good part of its ongoing hydel projects go on stream. Hydel stations are ideal to meet peak power demand and thermal stations to meet base demand. The 800-MW Koldam hydel project will be the first to go onstream towards end-2008 followed by two other projects in Uttaranchal adding up to 1120 MW. The company is also looking at two projects in Arunachal Pradesh that will, if implemented, add another 4,500 MW to its hydel capacity.

The mix will further change in the long-term when the company's plans to enter the nuclear generation segment turn into reality. Consultants have submitted a road map for the foray into nuclear generation.

Meanwhile, NTPC has addressed the issue of security for its most important fuel source — coal — by integrating backwards into coal mining. The first of its coal mines will commence production by the end of this calendar year and the stated aim is to have up to 25 per cent of its requirements met by captive mines in the next 10 years.

Ambitious programme for capacity-addition

The company plans to add about 22,000 MW to its capacity in the next five years, which appears a trifle ambitious if you consider that it added just over 7,000 MW in the last five years. But what lends confidence is that projects adding up to a little over 11,300 MW are already under construction and the company last year awarded contracts for a further 3,600 MW.

Importantly, NTPC's capex budget of Rs 12,792 crore for this fiscal is 63 per cent higher than last year's Rs 7,820 crore. And, again, the budget looks believable if you consider the extremely healthy cash generation in 2006-07 — the company had free cash of about Rs 12,000 crore as on December 31, 2006. Four straight years of 100 per cent realisation on its bills have clearly improved the cash flows and strengthened NTPC's finances considerably.

The company is also moving with the times by venturing into merchant power plants, which sell their power to the highest bidder and normally have no pre-allocated buyers. It has classified four of its upcoming projects — including the two Uttaranchal hydel projects — as merchant power plants. Given the 14 per cent peak power deficit and the existence of its own power trading arm, NTPC Vidyut Vyapar Nigam Ltd., the merchant power plants augur well for the company's revenue and earnings.

Provisional results

The 16 per cent increase in post-tax profits to Rs 6,726 crore and 17 per cent rise in net sales to Rs 30,638 crore during 2006-07 as per the provisional results were lower than what the market expected halting the uptrend in the stock. Any price weakness can be exploited to acquire the stock with a medium/long-term holding perspective.

Grindwell Norton: Buy

Investors can consider taking an exposure in Grindwell Norton, a leading player in abrasives and industrial ceramics with one-two year perspective.

At the current market price, the stock trades at about 11 times its expected calendar year 2007 per share earnings. A healthy demand outlook stemming from increased capex in user industries, increased focus on exports combined with Grindwell's strong foothold in the domestic market in certain product categories are likely to spur future earnings growth. It is also likely to benefit from the access to newer export markets and product sourcing from Saint Gobain, its parent company.

In the abrasives industry, Grindwell and Carborundum Universal together cater to about 75 per cent of the domestic demand. The abrasives segment of Grindwell is likely to drive future growth, given the positive demand environment for user industries such as steel or infrastructure. For the calendar year 2006, while the revenue contribution of the abrasives segment increased by 21 per cent, the segment profit jumped by 42 per cent. This apart, its recent acquisition of Orient Abrasives is also expected to contribute to the earnings stream. However, significant contributions from Orient Abrasives are likely to flow in from the second half of 2007 only. Contribution from the ceramics and plastics segment, however, is likely to be maintained.

For the calendar year 2007, Grindwell has outlined capex plans of Rs 20 crore for maintenance and de-bottlenecking. This is likely to help improve margins, which have been under pressure during the second half of 2006. The operating profit margins, during the quarter ended December 2006 had dipped by 280 basis points to 15.6 per cent. However, the pressure on margins is expected to ease with the company's cost reduction efforts. Any slowdown in the capex plans of the user industries and increase in imports from China remain principal risks.

Shoppers' Stop: Hold

Shareholders can retain the stock of Shoppers' Stop (SSL). The underperformance in retail stocks in recent months could well be recognition of the challenges in sustaining strong growth rates in a hyper-competitive retail environment. With a focus on the premium segment and a dominating presence in the departmental store format (which is relatively less contested), however, SSL remains a superior option among retail stocks. However, rising rental and employee costs could be a damper on margins in the near term. Any slow down in growth could cause valuations to temper; the stock remains richly valued at about 36-38 times the FY-08 per share earnings, assuming current growth rates. However, given the scarcity of options in the space, the stock could attract buying interest at lower levels.

Delays in store openings

SSLhopes to have four million sq. ft of retail space by 2010 from 1.1 million sq. ft now. With 20 stores and an additional six to open this fiscal, the retailer is behind its initial target of 39 stores by FY-08The company is, however, fairly positive that it will meet its 2010 target with improving competence on the part of mall developers. Despite a slower pace of store openings, revenue growth continues to be robust on the back of strong same-store sales, which was nearly 20 per cent in the December quarter. Such strong same-store growth could further boost profitability, as according to the management, its stores reach their peak profitability between three and five years from their opening.

Focus on premium

Operating margin at close to 10 per cent is better than its peers despite a comparatively low share of private labels in overall sales. The retailer focusses on the higher end of the market and is well-placed to partner with international retailers that seek an entry into the Indian market. The UK-based Home Retail Group is the latest partner, which will be introducing its Argos chain of stores, which sells products for homes through its stores, as well as online and via the telephone. The first store is expected to open by the end of this year.

Through its tie-up with the Nuance Group, it also recently won a bid to set up duty-free retailing for the Hyderabad International Airport; it bagged a similar concession in November last year for the Bangalore International Airport.

The concession of the Hyderabad airport, which is likely to commence operations in April 2008, is expected to earn $240 million over the next seven years. Such tie-ups appear to tap unexplored markets, which could have high growth potential if the current growth trend in discretionary spending continues. SSL has recently taken a 19 per cent stake in HyperCity, the hypermarket format operated by the Rahejas. This opens up a bigger opportunity in food and grocery retailing. The initial response to the store has been impressive with the store expected to break even within its first year of operation. However, we expect substantial competition in this segment from players with deep pockets. SSL has the option to buy a 51 per cent stake by December 31, 2008.

Margin pressure

Continued spending on lifestyle products and an improving share of private labels in the revenue mix has so far helped the retailer to stave off the inevitable margin pressure that could weigh on earnings growth in the medium term. With the industry in the throes of change, attrition levels remain high and a scarcity of talent in the middle management levels is leading to increasing employee costs.

While the management has indicated that it would only take up properties on realistic rental rates, its format lends itself to a greater presence in premium locations where rentals will be higher.

Several of the new stores that are likely to come up over the next couple of quarters are in the North where rentals are higher and this could skew the margins picture in the medium term.

Over the long term, however, once operational ramp up takes place, the pressure should ease, as these properties are also likely to command higher realisations per square feet.