Essel Packaging: Hold/buy on declines

Recommendation:Hold/buy on declines

Suresh Krishnamurthy

HOW WOULD you evaluate the impact of a deal, the terms of which have been disclosed only partially?

For Essel Packaging shareholders, this is perhaps their top concern. While the creation of Essel Propack, through the merger between Essel Packaging and Propack AG's laminated tubes division, sounds good, the financial implications of the deal still have to be outlined by the management. Given this backdrop, fresh investments need not be contemplated for now. Shareholders can hold on to their stakes considering that the deal is not completely devoid of its positive aspects.

What Essel says:

Essel Packaging's press release outlined the following:

*Essel would acquire a 100-per-cent-stake of the Mauritius-based special purpose vehicle Propack Mauritius, which controls Propack's operating entities in China, Indonesia, the Philippines, Venezuela and Colombia.

*Essel would issue 6.88 million shares, amounting to a 22-per-cent-stake, in the expanded equity in addition to $11 million in cash.

*The valuation of the merged entity was $350 million as assessed by Deloitte Haskins and Touche.

*Targeted sales for the merged entity for this fiscal will be Rs 371.50 crore, while profit after tax will be Rs 59 crore.

*Propack has patents for a ``revolutionary tube processing technology''.

*The combined entity would hold an 80 per cent market share in the Indian and Chinese markets.

*The merger would make Essel Propack the largest laminated tubes manufacturer in the World.

Analyst meet disclosures

Essel Packaging made the following disclosures in an analyst meet:

*The merger would raise the installed capacity of Essel Packaging from 1.3 billion tubes to two billion tubes.

*The cost of investments would decline due to the pooling of assets. The merged entity would not require more than $30 million in cash over the next three years.

Implications

While a broad outline of the terms of the merger has been made, Essel has not disclosed the profitability of the assets acquired. Details on that are important since manufacturing the laminated tube in India is more profitable than elsewhere. Without data on profitability, it is impossible to evaluate if Essel Packaging bought Propack cheaply or otherwise.

Indian companies have integrated operations manufacturing laminated web and other raw materials. While this makes these companies more profitable, most others in the world focus only on making the laminated tubes, buying the laminated web as a feedstock from suppliers. If operations of Propack AG are not similar to Essel's, it is highly probable that the operations of Propack AG are less profitable.

The status of Ras Propack Lamipack, in which Propack Holding AG holds a stake of around 40 per cent, has also not been made clear. It is clear that the assets acquired do not include those of Propack's Indian operations. However, Propack's, and now Essel's, plans regarding the Indian operations need to be outlined for the shareholders.

It has also not been made clear how Essel will now become numero uno globally. The world leader in laminated tubes is Cebal, which is part of France's Pechiney group. According to Pechiney's 1999 annual report, Cebal notched revenues of 527 million euros, with laminated tubes accounting for 78 per cent. In Indian rupees, the laminated tube making operations of Cebal is worth close to Rs 1,650 crore.

According to Essel, the merged entity's sales is to be Rs 371.50 crore for the year-ended March 2001. Seen in this backdrop, the numero uno spot can be justified only on a technical basis and Essel cannot even be considered for making a bid for the top spot, let alone as the global number one.

In the end, Essel would perhaps want us to believe that the acquisition has been cheap. However, the conclusions do not seem clear cut. The market value of the stock issued by Essel at Rs 450 per share is close to Rs 300 crore. In addition to the Rs 50 crore cash payment, Essel is shelling out close to Rs 350 crore. It is paying half its market capitalisation for capacities roughly half of what Essel has. While this seems reasonable, the acquisition has not been made cheaply. Also, the key question concerning the valuation of the deal would be the revenues and profitability of the assets acquired. The only way the acquisition can be considered to have been made cheaply is if the Essel Packaging stock is over-valued at the Indian stock markets now. If that is so, then the acquisition can be considered cheap.

Positive aspects

Notwithstanding these factors, the deal is not without its positive aspects. For one, the stock has been used to acquire assets at a time when the valuation of Essel Packaging is on a high, especially compared to the valuations commanded by the stock in the past. More important is the company's commanding position in the fast growing markets of India and China. The market for laminated tubes is growing robustly even in the mature markets of Europe. In this backdrop, the scope for the product in the emerging markets of India and China appear quite impressive. And to hold a unusually large market share of 80 per cent in these territories is a significant advantage.

The advantage for the merged entity also stems from the kind of industry in which it is operating. The laminated tubes industry, worldwide, has not attracted many players and the entry barriers are high. The industry is capital- and technology-intensive. Stabilising operations, even after setting up a plant, is not a trouble-free process ensuring that the existing players in the industry continue to hold onto their advantage. This has implications for the valuation of the stock since there are few industries in the world that offer existing players this level of security.

Another feature of the industry, especially in the emerging markets, is the need for continuous capacity upgradation. Consider the case of Essel Packaging. Essel's sales growth rate stagnated last year not only because of sluggish demand conditions, but also because it is operating at full capacity.

If investments are not made, as was not done last year, sales, profit growth and the return on networth would stagnate. In this backdrop, a larger entity with access to much larger cash resources would be in a better position to meet the demands for cash. Seen in this light, the acquisition by Essel does considerably strengthen its hands.

Questions over valuation

According to Essel, the valuation of the merged entity has been placed at $350 million or Rs 1,600 crore. It market capitalisation on an expanded equity base of around Rs 22 crore and at a market price of Rs 480 would be around Rs 1,050 crore. This suggests that the Essel stock is now undervalued by a significant 50 per cent. However, the assumptions behind the valuation placed on the merged entity are unknown and as such the suggested figure does not appear to serve any purpose.

Another figure cited by Essel Packaging is that the profit after tax of the merged entity for the present financial year would be Rs 59 crore. In such a case, on an equity base of Rs 22 crore, the per share earnings would be Rs 26.75. At the present market price of Rs 480, the stock is trading at a price to earnings multiple of close to 18 times the estimated earnings for the year ended March 2001. Based on this estimate alone, the valuation does appear to be on the high side, given the growth rates during this fiscal and problems associated with expanding capacity to enhance growth.

However, in its analysts meet, Essel Packaging also estimated profit growth rates of close to 50 per cent not only for the immediate year after March 2001, but also for the three-year period ending in 2005. Considering the lack of details regarding the operations of Propack AG's operating assets, these optimistic growth estimates lack a reasonable backing. If Essel is unable to engineer a growth in profits to Rs 59 crore by the end of this year for the merged entity, the valuations would indeed look stretched. In this backdrop, fresh investments need not be contemplated for now. Investors can take exposures in the stock after considering the company's performance for the full year ended March 2001, or in the event of a decline in valuations to less than 15 times its per share earnings.