Servalakshmi Paper - IPO Note Angel Broking maintains Avoid

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Servalakshmi Paper - IPO Note

Angel Broking maintains Avoid on Servalakshmi Paper

Servalakshmi Paper (SPL), part of the Servall Group, was incorporated in

November 2005. SPL manufactures printing and writing paper and newsprint.

The company’s plant is situated in Tamil Nadu and has total installed capacity of

90,000mn tonnes per annum, which makes it one of the largest single-location

plants in India.

SPL is tapping the IPO market with an issue size of `60cr in the price band of

`27–29/share, thus resulting in a public issue of 2.2cr and 2.1cr equity shares at

the upper and lower price bands, respectively, of face value `10, resulting in a

dilution of 49.7% and 47.9% stake.

SPL has embarked upon setting up an integrated paper mill with a capacity of

90,000mn tonnes per annum along with a 15MW captive power plant at a single

location. The total investment is estimated to be `340cr and the entire project is to

be completed in two phases. Phase-1 of the project has already been completed

and the company’s plant has commenced commercial operations from April

2010. Money raised through the IPO would be used for Phase-II, under which SPL

plans to add balancing equipment for improving productivity and manufacturing

value-added products. Funds would also be utilised for working capital needs.

The Indian paper industry is highly fragmented with nearly 700 manufacturing

units spread across the country, with capacity ranging from 5 tonnes per day to

over 1,000 tonnes per day. Total installed capacity is estimated to be at 9.18mn

tonnes, with production of 8.60mn tonnes. The industry has grown at a 6% CAGR

over the last few years and is estimated to grow at a 7.6% CAGR over the next

2–3 years, showing strong correlation with India’s GDP growth. Nearly 600,000

tonnes of new capacity is estimated to have been added in 2008 and 2009.

Industry estimates 500,000 tonnes of capacity addition over the next few years.

Outlook and valuations

Given that the best players in the industry have RoE of 14–16%, with cost of equity

for the top Sensex companies in a similar range, we believe investors should

approach investment in such a sector cautiously. SPL’s plant has started its

operations recently, thus the company will take some time to make profits.

Further, given the nature of the industry, any sort of price correction in paper

prices would lead to delay in profitability.

At the end of 6MFY2011, SPL had net worth of `40cr, while it plans to raise `60cr

through 50% dilution, which would value the company at `120cr, i.e., P/B of

1.2x. Even at the lower price band of `27, SPL would trade at a P/B multiple of

1.20x (1.24x at upper band), while its peers, which are profit-making and have

longer history of operations, are currently trading at an average P/B of 1.2x –

thus placing the stock relatively expensive. Hence, we recommend Avoid on the

IPO.

Key strengths

Strong expertise: Given Servall Group’s strong know-how in the paper industry due

to its long experience spanning across four decades, SPL has been able to set up

its plant at a lower cost compared to competitors. The project in totality would be

handled by promoter Group Company M/s. Servall Engineering Works (P) Ltd., an

expert in paper machinery design, engineering and manufacturing. As per

management and project consultant, total project cost as per industry norms was

estimated at ~`400cr, but, in actual, it came to `295cr, an approximate saving of

`100cr. SPL plans to further expand its capacity by 100,000 tonnes per annum.

Strong execution ability: The successful completion and implementation of Phase-1

of the project, without any hiccups or any over-run of cost, shows management’s

strong execution capability.

Logistical advantages: SPL’s paper mill is in close vicinity to Tuticorin Port (72km),

with the National Highway NH7 just 5km away. This enables faster transportation

of raw materials and finished products.

Risks and concerns

Promoter Group in a competing business: SPL’s promoters have group

concerns/entities that are also engaged in the manufacturing of paper.

Commodity nature of the business: The paper industry is highly commoditised

and lacks pricing power.

Key strengths

Strong expertise: Given Servall Group’s strong know-how in the paper industry due

to its long experience spanning across four decades, SPL has been able to set up

its plant at a lower cost compared to competitors. The project in totality would be

handled by promoter Group Company M/s. Servall Engineering Works (P) Ltd., an

expert in paper machinery design, engineering and manufacturing. As per

management and project consultant, total project cost as per industry norms was

estimated at ~`400cr, but, in actual, it came to `295cr, an approximate saving of

`100cr. SPL plans to further expand its capacity by 100,000 tonnes per annum.

Strong execution ability: The successful completion and implementation of Phase-1

of the project, without any hiccups or any over-run of cost, shows management’s

strong execution capability.

Logistical advantages: SPL’s paper mill is in close vicinity to Tuticorin Port (72km),

with the National Highway NH7 just 5km away. This enables faster transportation

of raw materials and finished products.

Risks and concerns

Promoter Group in a competing business: SPL’s promoters have group

concerns/entities that are also engaged in the manufacturing of paper.

Commodity nature of the business: The paper industry is highly commoditised

and lacks pricing power.

Outlook and valuation

Low per capita consumption and low penetration of key products

India constitutes 16.5% of the world’s total population; however, it consumes only

1.53% of the world’s total paper production. Per capita paper consumption is

estimated to stand at 8kgs, as against global average of 50kgs (Japan – 250kg;

Korea – 165/kg; and China – 42kg). An increase of 1kg in consumption on a per

capita basis will increase demand by 1mn tonnes. Coated paper forms only 10%

of India’s total consumption under the writing and printing paper category,

as against 40–50% in developed countries.

Currently, SPL is making losses as the plant has recently started its operations.

As the plant stabilises and its operations and utilisation start ramping up,

profitability should follow. However, we are not bullish on the sector and the

company due to the following reasons:

1) Commodity nature of the business: This leads to lack of pricing power.

2) Growth by capex only: The business requires continuous capex for growth, due

to absence of pricing power; price-led growth is limited and short-lived.

3) Perennially low RoE business: We have analysed the paper sector and

companies across the sector. As per our understanding of the sector, the best

players in the sector have RoE of 14–16%.

4) Industry running below capacity: Total installed capacity is estimated to be at

9.18mn tonnes with production of 8.60mn tonnes, indicating that the industry

is running below capacity. Hence, capacity ramp-up for SPL would be difficult,

given such a scenario.

Given that the best players in the industry have RoE of 14–16%, with cost of equity

for the top Sensex companies in a similar range, we believe investors should

approach investment in such a sector cautiously. SPL’s plant has started its

operations recently, thus the company will take some time to make profits.

Further, given the nature of the industry, any sort of price correction in paper prices

would lead to delay in profitability.

At the end of 6MFY2011, SPL had net worth of `40cr, while it plans to raise `60cr

through 50% dilution, which would value the company at `120cr, i.e., P/B of 1.2x.

Even at the lower price band of `27, SPL would trade at a P/B multiple of 1.20x

(1.24x at upper band), while its peers, which are profit-making and have longer

history of operations, are currently trading at an average P/B of 1.2x – thus

placing the stock relatively expensive. Hence, we recommend Avoid on the IPO.

Exhibit 3: Peer comparison

Company TTM P/B

BILT 1.5

TNPL 1.2

West Coast 1.1

J K 0.9

Average 1.2

Source: Company, Bloomberg