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Sunday, Oct 03, 2004

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Essar Shipping: Buy

S. Vaidya Nathan

AN INVESTMENT in the Essar Shipping stock at about Rs 25 may be considered. As there is likely to be a sizeable scaling up of revenues and earnings, the stock holds potential for considerable appreciation in value. A favourable industry environment in terms of freight rates, an expanded fleet, the contemporary nature of the fleet that ensures compliance with the increasingly stringent safety norms and fetches higher charter rates, and the emerging presence in the very large crude carrier (VLCC) space are likely to drive earnings growth.

What could be a damper is the likely increase in interest costs as Essar Shipping has stepped up its debt levels to bankroll the VLCC acquisition and its investments in Vadinar Port Terminal. The risk to our recommendation is a longer-than-anticipated time for the Vadinar Port Terminal project to yield revenues and the possibility of it requiring additional funding over the next couple of years. The first revenue flows may be at least three years away if the implementation timeline indicated by the company is adhered to. The risk could be mitigated to an extent, if the group ropes in a strategic partner.

The freight market — tankers and dry cargo — has revved up over the past few months after slipping earlier this year from all-time high levels. The improvement in freight rates has been reflected in an impressive performance in the April-June quarter with revenues rising by about 40 per cent. It was the exchange rate-linked losses that ensured only a marginal rise in post-tax earnings.

The firm trends in freight rates and the expansion of the fleet are likely to be reflected in a more pronounced manner in the revenue streams of the next couple of quarters. The strength in the crude oil market suggests that the higher tanker freight could continue to be a growth driver. The acquisition of VLCC has come at a time when freight rates in this segment have been buoyant.

The firm undertone in commodity prices — especially metals and ores — is likely to support the dry cargo freight market, as it indicates the underlying strength in demand. Though the Chinese economy is moving towards a sustainable and slightly lower growth rate, the Olympic Games of 2008 are likely to ensure a healthy demand for metals and other commodities.

Even as the macro-environment appears encouraging, it is the sharp rise in the debt burden that could affect earnings growth. Healthy cash flows from operations could lead to a pruning of debt levels over the next couple of years. Concerns regarding corporate practices and the risk of de-subsidiarisation are also cause for concern. But this aspect appears to have been largely priced in at the present valuation levels.

If Essar Shipping maintains the pace of growth of the first quarter of FY-05, we expect it to close the year with earnings growth of about 35 per cent. The stock trades at a valuation of less than four times its likely FY-05 earnings.

The stock is appropriate for investors with a higher risk appetite. Buy with a one/two-year perspective, but ensure you book profits if there is a sharp surge or if target returns are met.

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