Stocks that merit penciling

S. Vaidya Nathan

Recommendation

Ballarpur Industries: Hold

Tamil Nadu Newsprint: Hold

ITC Bhadrachalam Paperboards: Buy

Seshasayee Paper, West Coast Paper: Hold

THE PAPER industry is in a downward cycle. To a large extent this has been factored into the stock prices which have receded from their highs of 2000. Ballarpur Industries (BILT) is down from Rs 91 to Rs 39, ITC Bhadrachalam from Rs 73 to Rs 40, and TNPL from Rs 47 to Rs 21.

The earnings outlook for these companies in 2001-02 is unlikely to be as good as in the last two years. At best, the earnings may remain flat. Yet, this may not be a good time to cut exposure in this sector. It may be better to wait 12-18 months for an improvement in the industry cycle.

If the valuations drop further in the next six months, it may be a good time to consider taking exposure in the sector. But investors need to be patient for the next cycle to get better prices. At the present valuation levels, would-be investors need look no further than ITC Bhadrachalam (which will now mean taking exposures in ITC due to the merger), BILT and TNPL.

Suitability: Paper industry stocks are appropriate only for investors comfortable risking investing in a cyclical business. The cycles also tend to turn quickly and only those who can keep track of the price trends and act on them should consider taking exposures.

Investors would also have to use any uptrend triggered by a change in the business cycle to book profits. A buy-and-hold strategy will not work in the sector as stock price performances over the last 12 years shows up this strategy in poor light. Across time horizons, investors would have suffered steep losses in all stocks. So a `buy, hold and book profits' approach is the one that can deliver value.

BILT

Through a process of restructuring and acquisition, the company has emerged a major and focussed player in the paper industry. With the acquisition of Sinar Mas at a price of Rs 530 crore, the company's capacity has been enhanced to around 5 lakh tonnes.

From a long-term perspective, this acquisition is positive. But in the near-term, two factors stemming from the acquisition may act as a dampener on the stock. The first is the fact that Sinar Mas has a lower reported profitability level compared to BILT. In 2000-01, it recorded Rs 7 crore profits on a Rs 404-crore turnover.

In contrast, BILT had profits of Rs 100.28 crore on a turnover of Rs 1,593.2 crore. The process of acquiring BILT Graphics (which has the Sinar Mas unit) from closely-held family-owned firms and its merger could also take six months to a year.

The Sinar Mas effect may be felt in BILT's bottomline only in 2002-03. The second factor relating to the acquisition, and which could be seen as a negative, is the impending expansion in the equity base. A Rs 250-crore rights offer is planned and this may mean a rise of at least 50 per cent in BILT equity of Rs 70.55 crore, given its current share price.

This, coupled with the lower profitability of the Sinar Mas unit and the sluggish trend in paper prices, could put pressure on per share earnings. For shareholders, it may, however, be better to stay invested to capitalise on the re-rating of the stock when the industry cycle turns.

For the second quarter -- July-September 2001 -- BILT reported sales of Rs 384.63 crore and profits of Rs 17.43 crore -- both with only very modest increases over the corresponding period of 2000.

ITC Bhadrachalam

The company's status as a `paper-alone' entity is drawing to a close. The company is to be merged with ITC at a swap ratio of one share of ITC for every 16 shares of ITC Bhadrachalam. Though the ITC Bhadrachalam shareholders may have had reasons to expect a better swap ratio, the die, in this regard, is cast.

Shareholders who hold on to ITC Bhadrachalam and those buying the stock would essentially have exposures in ITC. With the merger, ITC would be a more diversified business. It already has a paperboard business under Tribeni Tissues, largely for internal use.

ITC Bhadrachalam is a contemporary unit whose profitability in the next uptrend in the paper industry cycle may be vastly superior. Between 1999 and 2000, the improvement in prices and volumes helped the company move out of the red.

ITC also plans to invest Rs 1,500 crore in the paper business over the next five years, having identified it as a growth sector where it invests the cash flows generated by the cigarette business. With this kind of support, ITC's paper business would, with BILT, be at the top end in terms of scale of operations.

Though ITC's cigarette business may face restrictions on volume growth, it may generate a 15-20 per cent growth in earnings/cash flows comfortably over the long term. With paper, it may be an exposure worth taking now since ITC is a frontline stock sought by institutional investors and has good liquidity (both of which was not the case with the ITC Bhadrachalam stock).

ITC shareholders should hold their exposures and get ITC shares once the merger is completed. Fresh exposures can also be considered as the downside risk in the merged entity is small and the odds are in favour of better valuation for the ITC stock when the broad markets move up (which may take six months to a year).

TNPL

With a fairly contemporary unit, sizeable capacities, which would be 2.25 lakh tonnes soon, and reliance on bagasse (the availability of which is not a problem) TNPL is one of the industry's better options. The use of cash flows generated in 1999 and 2000 when the going was good is also a favourable factor.

The cash flows have been used to cut debt and also implement measures to raise capacities from 1.8 lakh tonnes to 2.25 lakh tonnes at Rs 125 crore. These factors could reflect favorably on the earnings stream when paper prices start to improve. Shareholders can stay invested.