We expect CAGR 29% rise in net sales during FY07-FY09 for Pitti Laminations Ltd. (PLL) backed by the increase in demand from electrical equipment manufacturers and also by the enhanced capability of the company. We have used PE based approach to value PLL. With its current business set-up the Price to-Earnings multiple of the company should top 10. At the current market price of Rs.72, the stock is trading at 5x and 4x to our FY08 (E) EPS of Rs.13.3 and FY09E EPS of Rs 18.6 respectively. We recommend investors to ‘Buy’ into the stock with a price target of Rs.130 over a year’s time period.

Investment highlights

􀂄 Healthy order flow

With the consistent healthy order flow to the domestic electrical equipment manufacturers, we expect consistent revenue growth potential for this upstream electrical manufacturing service provider.

􀂄 Healthy order book position

Healthy current order book of 22,000 MT, approximately equivalent to Rs.2.3bn coupled with enhanced capability would propel the topline of the company in the short to medium term.

􀂄 Ongoing expansion

Completion of the expansion of the additional 6,000 MT capacity by August 2008 and with the streamlining of the business processes through organization-wide ERP implementation will lead to better efficiency in processing and resource management.

􀂄 Critical entry barrier

Good customer list that include Alstom, ABB, Crompton Greaves, Siemens, Suzlon Energy, BHEL and General Electrical (USA) would remain a considerable entry barrier for new entrants.

Brief business overview

PLL is an upstream manufacturing service provider, engaged in the manufacture of electrical steel (CRNGO based) stampings and laminations, particularly Stators (The static part in the electric motor) and Rotors (The moving part of the motor), which form a critical part in all types of motors, alternators, pump sets and DG sets. It also manufactures tools, jigs, fixtures and moulds for electrical equipment manufacturers. With the emerging business focus of the electrical equipment manufacturers in the country and cost reduction effort of the multinational equipment manufacturers in Europe and US the manufacturing operation of the company is gradually becoming integral for these equipment manufacturers. The electrical equipment manufacturers on their part also maintain small in-house capacity for the manufacture of these ancillary parts. But due to increase in orders these manufacturers put maximum emphasis on services rather than increasing their own manufacturing base in the relatively low value items. This put PLL in an advantageous position to cater to the need of these manufacturers by providing services with economy of scale and enhanced process efficiency.

􀂄 Consistent order growth for downstream capital good manufacturers
Currently the power equipment makers are witnessing consistent increase in orders due to ongoing expansion of the generation capacity in the country. PLL provides its lamination and stamping services to the customers like Alstom, ABB, Crompton Greaves, Suzlon Energy and Siemens in the domestic market. It exports a significant volume to General Electric of USA. According to the management currently it has a pending order backlog for 22,000 MT out of which around 10,000 MT is for exports, which include the core dropping (The fabricated exterior body that carry the stator and also support the rotor body by maintaining the air gap between the two) order from GE.

􀂄 Streamlining the expanded business process by the end of second quarter of FY08

Currently the company has two manufacturing units with total capacity of 17,000 MT. The third unit with capacity of 7,000 MT is under construction but partial production has already been started in that unit. Out of the total project cost of Rs.400m, Rs.200m crore has been spent so far which has been financed through debt and equity (Money raised last year). This project will get completely commissioned by the end of second quarter of FY08. Further the company is in the process of implementing ERP application for streamlining the business processes of the company. We therefore understand the current modernization and expansion plan of the company would get completed by the end of the second quarter

During the 9 months period of FY07 the net sales of the company has grown by 77% YoY to Rs.1,037.8m mainly due to increase in exports and consistent demand from the domestic customers. However, according to the company, the operating margin fell 300bps firstly due to design loss for some foreign customers orders and secondly due to non timely pass on the rise in raw material prices to the customers. Again due to rise in debt for the ongoing modernization and expansion plan the interest cost has risen by 168%. This resulted in 42% rise in net profit to Rs.71m during the nine-month period.

Financials and assumptions – Going ahead

􀂄 Assumptions

􀁺 We assume that the proposed expansion of phase III plant (Capacity of 7,000 MT) of the company would be over by the end of the second quarter of FY08 and expect a total capacity utilization of 91% and 96% for the whole capacity of the company during FY08 and FY09 respectively as against the current level of 91%.

􀁺 The company derives 45% of its turnover from exports. But the appreciation of Rupee would have a negligible impact on the margins, as we believe that it would get negated with increase in financial efficiency of the company on the one hand and increase in import content in the raw materials on the other. We also believe that the company would try to renegotiate the price terms to factor in the rise in rupee. Therefore our EBITDA margin expectation of 14% for FY08 and that of 15% for the company is reasonable as against expected 13% for FY07.

􀁺 We have assumed improvement in process efficiency where the ratio of finished product to scrap volume would improve from 60% to 62% in FY08 and FY09 respectively.

􀁺 We have assumed average finished output price of Rs.92,000/MT for FY08 and due to the addition of more value added revenue in the form of core dropping contracts from GE average finished output price of Rs.1,01,000/MT has been assumed for FY09.

􀁺 We believe the entire cost of the expansion and modernization would be financed from debt and internal accruals and there would be no further dilution of equity. Based on the above assumptions and better downstream industry outlook we expect CAGR of 29% of net revenue and 45% of net profit of PLL for the period of FY07-FY09.

Concerns

Although the company passes the rise in raw material cost to its customer, but it is not timely. So the fluctuation of quarterly profitability cannot be ruled out. Any significant rise in rupee value with respect to dollar would put adverse impact on the profitability of the company.

Valuation

We have used PE based approach to value PLL. Thus being an upstream manufacturing service provider for the high growth electrical capital goods sector, we believe PLL should be valued at 50% of the average PE for the electrical capital goods sector. Again due to lack of significant service content the business scaling would largely depend on the volume and process efficiency, which in turn would largely depend on the expansion of capacity. Also the volume and revenue growth largely depends on the order flow from the downstream players, as there is little opportunity to sell the products independently. However on the positive side, as it does not compete with low end unorganized stamping service providers so we believe the company would continue to get orders from its existing customers due to its niche manufacturing focus. Thus on the whole with its current business set up, we believe the PE multiple for PLL should justifiably top 10x. At the same time, we also believe that the company; after its recent expansion cum forward integration projects, would incorporate more forward integration initiative in to its business processes without increasing capacity in its core manufacturing process. This will help in improving its manufacturing margin in the medium to long term. Thus looking at company's impending forward integration initiative and consistent order flow from the major customers of the company in the domestic market and from foreign customers as well, we believe a price of Rs.130 is achievable in a one-year time, which would discount our FY08 EEPS of Rs.13.3 and FY09E EPS of Rs.18.6 by 10x and 7x respectively.