28 June 2011

Buy Lanco Infratech: Perdaman’s A$3.5bn claim is currently unsubstantiated:: Nomura research,

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COMPANY QUICK COMMENT
 
In response to media reports of Perdaman suing Lanco in Western Australia and seeking A$3.5bn in damages for
breach of an agreement (by Griffin Coal) to supply 2.8mtpa for 25 yrs starting 2014, Lanco stated: 1) it has not
terminated the agreement; 2) Perdaman’s claims are baseless; it has not filed a statement of claim in the Court
explaining the basis of the damages. In our view, 1) the damages sought by Perdaman appear unsubstantiated, and
2) there is scope for both parties to settle. In our view, the sharp fall in Lanco’s stock price on Friday is an
overreaction; we maintain our Buy rating.
 
Price target: 51.0 INR
Perdaman’s A$3.5bn claim is currently unsubstantiated; price correction appears
overdone
Event
As per media reports on June 24-25 (including Lanco Infratech faces AUD3.5bn lawsuit in Australia, Press Trust of India) Australiabased Perdaman Chemicals and Fertilisers Pvt. Ltd has filed a lawsuit against Lanco in the Supreme Court of Western Australia
seeking compensation of A$3.5bn for Lanco’s alleged non-compliance with the coal supply agreement between the two parties
(supply 2.8mtpa coal for a 25-yr period starting 2014). The reports cite Perdaman’s Chairman & MD stating that: 1) Legal
proceedings have been commenced as Lanco has gone back on contractual obligations, which is a breach under Australian
consumer law, 2) Perdaman is facing road blocks with regards to the works of the proposed A$3.5bn urea plant (construction was
scheduled to begin in July 2011) and has also suffered damages, and 3) A hearing on the case is expected on July 27.
Subsequently, in a press release, Lanco stated that: 1) Perdaman''s claims are baseless and without merit, and 2) Perdaman has not
filed a statement of claim in the Court explaining the basis of its damage claims; if these documents are filed, then Lanco will
vigorously defend these claims in Court. Further, media reports (Perdaman lawsuit ''baseless'', co ready to supply coal: Lanco, PTI)
quote Lanco’s CEO – Business Development as stating that Lanco has not terminated the coal supply agreement and is ready to
comply with the pact that is in place.
Analysis
1.     Griffin Coal’s coal supply contract with Perdaman was executed in December 2010 by its Administrators (Korda Mentha);
Lanco had been identified as the successful buyer of Griffin Coal at that time.
2. Perdaman’s 2mtpa Collie Urea Project is expected to be completed by 2014; media reports suggest that so far Perdaman
has spent A$200mn on this project from its internal resources.
3. The basis for seeking compensation of A$3.5bn (Rs166bn) is not clear as Perdaman has not filed a “statement of claim in
the Supreme Court explaining the basis for its claim and how it arrived at damages claim of the compensation amount.
4. As the matter is sub-judice, there are no comments beyond the press release from Lanco’s management. In our earnings
model for Griffin Coal (which forms part of Lanco’s consolidated earnings forecast), we have assumed offtake to Perdaman
to commence in FY2015; pricing of contract is assumed at ~A$60/ton in FY15F with an annual escalation based on
Australian CPI.
Implications
1.     In our view, while it is premature to speculate on the Court’s decision on this case, we note that: 1) the A$3.5bn damages
stated to be sought by Perdaman are currently unsubstantiated. 2) As Lanco has stated that the agreement has not been
terminated, and supply is only slated to commence in FY2015, there seems to be ample scope for both parties to settle this
issue.
2.     From Griffin Coal (Lanco’s) perspective, the potential undiscounted revenues from coal supply under the 25-yr contract to
Perdaman would be A$5bn-5.5bn as per our forecast. The contract with Perdaman would account for ~20% of Griffin’s longterm coal offtake and revenues.

3.     Clearly, the 9% drop in Lanco’s stock price on Friday (down to Rs22.9/share on the BSE) was primarily triggered by this
news report; we view this as an overreaction to the filing of the lawsuit. At current price levels, the stock is trading at 0.7x
FY13 P/B and 4.1x FY13 P/E.
4.     There is no impact of this lawsuit in our earnings forecast for Lanco. However, we do note that relative to our assumptions,
the likelihood of 3-6 month delays in project commissioning does imply a downside risk to our earnings forecast for the
company.
 
Valuation Methodology and Investment Risks: We use a sum-of-the-parts (SOTP) valuation methodology for Lanco. We discount FY12-
14F free cash flows (effectively the FCF from existing Rs270bn order backlog) at 14% CoE to value the EPC/construction business, the
power business using a milestone-adjusted FCFE valuation at 14% cost of equity, the power trading business at 7x FY12F P/E, the real
estate business at a 30% discount to NAV calculated using 20% WACC, and toll roads using DCF at 15% cost of equity. Key risks: 1)
Interlinked business lines entail ‘cascading risk’ to earnings; 2) High dependence on coal/gas supply via domestic linkages; and 3) Equity
raising to fund 10.6GW under-development pipeline.


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