Essel Packaging: Hold

Recommendation: Hold

Suresh Krishnamurthy

FRESH investments need not be contemplated in the Essel Packaging stock for now.

The profit growth in the first half of this fiscal was lacklustre. On the other hand, the merger proposal with Propack Holdings of Switzerland has significantly changed the company's operational profile. The acquisition has made Essel Packaging the No.1 player globally. However, the impact of the merger proposal on the operational profile appears unclear. While fresh investments need not be contemplated, shareholders can stay invested.

Trying times: In the backdrop of the trying circumstances plaguing the industry, Essel Packaging performed creditably for the quarter-ended September 2000. The company reported a 11 per cent increase in profits on the back of a 6 per cent increase in sales. The operating profit margin improved marginally to 40 per cent from 39 per cent in the corresponding previous period. For the six months ended September 2000, sales rose to 4.4 per cent and profits to 12.9 per cent compared to the corresponding previous period.

Essel's performance needs to be seen in the backdrop of the sluggish growth in the sale of personal products such as toothpastes, facial cream, and so on -- products that require laminated tubes manufactured by Essel Packaging.

Given this situation, Essel's sluggish sales growth is only to be expected. However, significantly, in spite of a sustained increase in raw material costs due to the surge in crude oil prices, the operating profit margin has not been affected.

Essel Packaging must enhance its profit growth rate if it is to generate a decent return on its net worth and sustain the improvement made in 1999-2000. For Essel Packaging, the critical issue has always been the poor return on net worth. Till March 1999, the return on capital employed was only around 12 per cent. The stock, thus, merited little attention from a long-term investment perspective.

The poor return on net worth is essentially a factor of the industry. With stiff competition and strong buyers, the company's ability to improve returns has always been constrained. Added to this was the need to expand capacity every two years. However, for the year-ended March 2000, Essel was able to increase the returns to 17 per cent. But this improvement was accompanied by a deterioration in cash flows from operations. For this financial year, the cash outflow due to generous dividend payments in 2000 would also be a factor in enhancing the return on net worth. Still, a higher profit growth may be essential to effect a sustained improvement.

If the profit growth for the first half is maintained, the per share earnings for the financial year would be around Rs 20. The stock trades at Rs 448, at a stiff price-to-earnings multiple of around 23 times its anticipated earnings. Balancing the stiff valuations is the merger with Propack, which is expected to result in an expansion in equity by 25 per cent and an accretion to profits by around 30 per cent. In other words, the merger is expected to be accretive to per share earnings.

If the merger reduces the need for cash, the impact of return on net worth would be positive. However, Propak's operations are not as profitable as Essel Packaging's. The overall impact of the merger on Essel Packaging's profitability parameters need to be taken into account. In this backdrop, while shareholders can stay invested, fresh investments need not be contemplated.