The Hindu Business Line : Cash-rich, and investing wisely too

FOR MANY companies the cash register has been ringing over the past three years. Deploying this money in investment ideas that will deliver value to shareholders over the long term has now assumed importance. Our top ten picks to achieve this are Bharat Electronics, Bharti Tele-Ventures, Container Corporation of India, Great Eastern Shipping, Gujarat Ambuja Cements, Indian Hotels, Reliance Industries, Sesa Goa, Siemens and Tata Steel.

BPCL (Bharat Petroleum) would have also made it to the list, but for the uncertainties surrounding the pricing of oil products and the losses it is required to fund. From the mid-cap and small-cap space, Tata Tea, Greaves Cotton, NDTV and Coromandel Fertilisers, too, were in the reckoning, but could not make it to the top ten.

Focus on cash flows

As industrial growth and commodity price cycles have been on a high for close to three years, companies across sectors have minted money on an unprecedented scale. Industrial growth remains robust; but commodity prices, with the exception of oil and petroleum products, appear to have peaked.

In categories such as steel, aluminium and copper, there has been a substantial decline this year. The same goes for freight rates, too. But, by and large, prices are likely to stabilise at higher levels, unlike in the past.

In this backdrop, earnings and cash flows in absolute terms are likely to remain in line with the trends of FY05.

Growth may peter out to more moderate levels, and may even decline a bit in a few sectors. From a long-term perspective, the focus should be on how companies use their cash flows and balance-sheet strength, as they have also cut debt, replaced high-cost funds and taken one-time charges as part of the cost-reduction exercise.

In drawing our list, subjective judgment has also been a key factor. By the end of FY06, these 10 companies would have generated Rs 1,00,000 crore in cash from operations that could be used for investment and dividend payment. Add a dash of debt and one gets an idea of the strength these companies can derive from in scaling up their businesses over the next three-five years.

Why they are favourites

Across sectors, many a company has announced investment plans over the past 18 months. This would translate to higher revenue and earnings growth over the long term, even if product pricing moves to lower levels.

For two-three years interest and depreciation charges are bound to rise and cut into shareholder earnings. In this macro backdrop, we shortlisted these companies for the following reasons:

They are the leading players in their industry segments with a sustainable edge over competition, and well-placed to capitalise on growth opportunities;

They have top-of-the-chart operating margins that would enable them to absorb the effect of lower price levels as well as higher interest and depreciation charges when their expanded scale of operations take effect;

Their investment plans focus on expanding their core businesses through new capacities and acquisitions, and proven ability to execute growth plans efficiently;

They have the ability to implement growth plans with marginal expansion, if any, of the equity base. Only Tata Steel and Gujarat Ambuja Cements may be required to offer fresh shares and expand equity by 10-20 per cent, given the order-of-magnitude jump in capacities and acquisition plans respectively. This means the benefits of the investment plans would flow almost completely to existing shareholders;

Their financial strength would enable them to source debt funds in the domestic and overseas markets at finer rates relative to competition, and still remain comfortably leveraged with debt accounting for a moderate part of shareholder funds;

They have a track record of attractive dividend payouts despite using only a small proportion of their earnings; this suggests room for substantial expansion in payouts in the years ahead;

They pay hefty taxes that impart a higher degree of credibility to their earnings and cash flows;

Their quality of management and high degree of transparency. On the latter, there have been some have concerns vis-à-vis in the case of Reliance case, as the recent developments brought to light Industries in the wake of the battle between the two Ambani brothers that saw many hidden aspects of intra-group investments come to light; and ;

Their ability to maintain profitability at healthy levels, even in difficult years for the industry.

As the scale of operations is slated to increase over the next three to five years, the cash flow generation is likely to remain at impressive levels. These stocks also trade at attractive valuations from a long-term perspective, which enhances the prospects for gains over a three/five-year period.

Explaining a few picks

The only PSU considered is Bharat Electronics. Unlike the oil sector, policy developments and politically-influenced moves may not be a negative in this case. Given its business profile, with a high proportion of revenues derived from supplies to the Defence sector, Bharat Electronics does not face risks of the kind that confront oil or banking sector companies. It has developed several new products that are likely to cater to emerging demand from the non-Defence sector too. This should lead to robust top-line growth bolstering the revenue stream from an order book that covers at least two years of revenues.

Bharti Tele-Ventures may appear substantially overvalued compared to the other stocks in the list. Despite the rapid growth in its customer base, revenues and balance-sheet size, it remains a growth story. We believe there is a substantial territory to be covered on the upside in adding more users to its service.

This process may be accompanied by lower average revenue per user and a few percentage points may be knocked off from its operating profit margins over a three-year period.

By focusing on augmenting its customer, base even if it means a decline in average revenue per user, Bharti has a strategy that is likely to deliver impressive growth and neutralise, to a great extent, any decline in margins. Its financial strength, as it approaches this expansion phase, also places it at an advantage.

Indian Hotels has so far focused on the luxury hotels segment. Over the past year, it has made a foray into the budget segment with its indiOne chain of hotels. It has met with success in Bangalore and plans to expand its footprint to ten more cities. The boost in domestic leisure travel, the enhanced spending power, especially of persons employed in the IT sector, and the success enjoyed by `value-for-money' products/services in other industries are factors that point to a success story for indiOne. This initiative is likely to augment its investments in the luxury hotels segment.

For several years, Great Eastern Shipping may not enjoy a rise in freight rates that remotely matches the trends over the past two-and-half years. There is a downward bias to freight rates as fleet additions happen at the global level. Major shipyards across the world have order-books that extend to 2009; as deliveries are completed, there is likely to be a net addition to fleet levels even if one counts out the sizeable scraping that is imminent to comply with the increasingly stringent safety norms.

In this backdrop, it is the growth in tonnage and the acquisition of a more contemporary fleet of oil/ petroleum product carriers that is likely to support steady growth of revenues at Great Eastern Shipping. With this stock, the key factor to reaping returns is the ability to hold the stock through a business cycle. Through this period, a dividend yield of about 6 per cent would keep the value of investment ship-shape.

Several nascent large-cap plays

EIGHT of our picks — exceptions being Reliance Industries and Tata Steel — have graduated to large-cap status during the ongoing bull market since mid-2003; barring Bharti, the rest are on the threshold of becoming large-cap stocks.

The process of addition to wealth from this stage may take longer. But it will be rewarding for investors with patience.

The principal risk that these companies (just as rest of the corporate sector) face is the rising price of crude and the likelihood that it will remain at levels far higher than in the past several years.

For Reliance Industries, such a trend would magnify earnings and cash flows; its vulnerability to this factor would be from an arrangement that would require it indirectly share the burden of subsidy on LPG, kerosene and diesel.

If you own these stocks, remain invested. Should you invest in these stocks now? We remain positive on their prospects.

Investors should make effective use of any declines linked to a broad market weakness to accumulate them over the next 12-18 months.

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