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Welspun Corp Ltd
OW: Earnings miss ok; missing orders worrying
1QFY12 reported earnings were lower than our and consensus
estimates but declining order book worrying
We expect near term under performance but see signs of
revival in global pipe market in next six months
We maintain our long term bullish outlook and reiterate our
Overweight rating with INR265 target price
1QFY12 earnings were 15% below our and consensus estimates but we don’t worry on
that count Welspun reported net profit of INR1.2bn (flat qoq and decline of 38% yoy) largely
because of lower sales. The company attributes lower sales to the delay in shipment of 30,000
tonnes of pipes and some shutdown in plant. As in the previous quarter, the margins from the
plate mill remain weak and the company is now guiding for weakness for one more quarter.
Order book decline is worrisome. The order book declined 7% qoq in value terms and 12%
qoq on volume terms, with the pipe order book reaching its lowest level seen in at least the last
five quarters. If we exclude the inventory to be shipped, the pipe order book would have
declined by 16%, which to us is worrying. We expect the stock to remain weak in the near
term in absence of any notable increase in order book.
However, Global E&P market is showing signs of revival and pipe market likely to
follow, albeit with a lag. Global rig count is now reaching close to its 2008 highs,
indicating heightened E&P activity and there is a renewed interest in exploration activity
in the Gulf of Mexico. Our Middle East research team also points to increasing E&P and
infrastructure activity in Middle East. Both these regions are expected to be the main
drivers of growth in E&P spend and are in the process of giving orders for EPC
(Engineering, Procurement and Construction) and FEED (Front End Engineering Design).
We believe orders for pipes follow once EPC and FEED orders are given and hence we
expect to see a rise in order book for pipe manufacturers by end-2011. Welspun should
benefit as it has plants in these high activity regions.
Valuation and risk. We remain positive on the outlook for pipe demand and capacity
expansion projects. Given the cyclical nature of order inflows, we value the company on PE.
We believe its fundamentals deserve a multiple of 9x and above, reflecting a 17% average
ROE and 10% long-term earnings growth. But taking into account the higher risk perception,
we value it based on a PE of 7x on FY13e EPS of INR37.7. This generates a rounded target
price of INR265 and an OW rating. Our biggest concern on stock remains corporate
governance and the overhang of the SEBI order. A 10% increase in pipes EBITDA/tonne can
increase our earnings estimates by 15%.
Key takeaway from conference call
The company’s share of EBITDA from Leighton was INR180m with the JV contributing INR130bn
to profit before tax. Leighton currently has INR50bn of order book.
The pipe business continues to make INR11,000/t of EBITDA and plates business continues to
remain weak contributing INR3,000/t of EBITDA. The company expects margins to improve from
the current levels with the quarters ahead.
The company is optimistic on the resurgence of the market and expects strong orders from Saudi Arabia
and United States. The order book from its US and Saudi Arabia mill is already about nine months of
sales. However, Africa and Latin American markets continue to remain weak in the near future.
Welspun Maxsteel, which was recently acquired but yet to be consolidated in the business is
generating EBITDA of INR550m and company expects to go ahead with its plan of setting up a
greenfield steel plant after getting all environmental approvals.
Consolidated Net debt at end of June 2011 – INR22,610m.
Investment view
WLCO stock underperformed the market by 41% over the past 12 months, largely due to a decline in orders
and corporate governance issues. We believe that its focus on the export market, capacity expansion, and
benefits from backward integration with a plate mill, a stronger management team, and entry into engineering,
procurement, and construction (EPC) projects will enable it to achieve an earnings CAGR of 14% over FY11-
14. We expected the stock to languish in the first half of the year on corporate governance issues, but
performance should improve in the second half with order book growth helping to allay investor concerns.
Valuation
We expect WLCO to record a 14% CAGR on sales volume from FY11-14 primarily on the back of
350,000 tonnes of new capacity coming on stream in FY12, 300,000 tonnes of new capacity in Saudi
Arabia, and 100,000 tonnes of HSAW in mid-FY11.
Given the cyclical nature of order inflows, we value the company using a PE methodology. In the past
five years, Welspun stock has traded at a one-year forward PE of between 5x and 35x, depending on how
“hot” the E&P capex cycle was. We believe that Welspun’s fundamentals deserve a multiple of 9x and
above, reflecting 17% average ROE and 10% long-term earnings growth. However, reflecting the
increased cost of capital to 16%, we value the company on a PE of 7x on FY13e EPS of INR37.7. This
generates our 12-month target price of INR265.
Under our research model, for stocks without a volatility indicator, the Neutral band is 5ppt above and below
our hurdle rate for Indian stocks of 11%, or 6-16% around the current share price. Our INR265 target price
implies a potential return, including dividend yield, of 54.4%, which is above the Neutral band; thus, we
reiterate our Overweight on Welspun shares.
Risks and sensitivities
The biggest concern for investors, in our opinion, is corporate governance. We believe the stock will
continue to languish for some time and could underperform further if the Securities and Exchange Board
of India (SEBI) subjects the major shareholders to any penalties; the market regulator is investigating the
company in connection with alleged price-rigging. However, longer-term, we expect the robustness of the
core business to take precedence for investors.
Sensitivities: Our earning estimates and target price are sensitive to volume growth and margins trends. We
calculate that a 10% increase in LSAW pipe volumes would increase net profit by 4%. A 10% increase in
HSAW pipe volumes would increase net profit by 7%. A 10% increase in ERW pipe volumes would
increase net profit by 1%. A 10% increase in plate volumes would increase net profit by 3%. And a 10%
increase in blended pipes EBITDA/tonne would increase net profit by 15%.
