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S. Vaidya Nathan

Steady growth in the writing and printing paper segment may provide limited upside to earnings.

SHAREHOLDERS can reject the rights offer of The Sirpur Paper Mills now, as the prospects for appreciation are not attractive. The benefits of capacity expansion and modernisation, which are to be part-financed by the rights offer, may be reflected fully in the profitability and earnings only from FY-08.

Till then, it may be a story that is tied only to price trends in paper. Earnings growth linked to this factor may be moderate and is unlikely to drive an expansion in the stock valuation level. The offer is priced at about seven times its likely per share earnings for FY-05 and a higher multiple of 12 on the expanded equity base after the offer.

The stock trades at about Rs 100 and could decline in the post-offer period. There are also several paper industry stocks that are likely to be better placed on the scale of operations and profitability even after Sirpur Paper completes its expansion.

The paper sector is unlikely to attract substantial institutional investor interest. The outlook for the price of various paper varieties points to, at best, moderate increases at the international and domestic levels.

With import tariffs lower at 15 per cent and the rupee ruling high than a couple of years ago, domestic prices are likely to tail international prices trends. This is likely to cap earnings growth.

In this backdrop, it is believed that funds could be deployed in stocks from sectors that are more attractive from a growth perspective. More so, as there is likely to be a waiting period of at least three years before the benefits of new projects get reflected in earnings.

Till then, expansion in earnings is likely to trail that in the capital base; the equity overhang is also to likely dampen valuation levels. So, the opportunity cost of locking in funds in the rights offer is likely to be stiff.

We have taken a negative view of the rights offer despite a fairly impressive track record, especially over the past three years.

There was a healthy growth in revenues aided by higher volumes and modest price increases. Sirpur Paper has also cut down its debt and replaced high cost loans. This, too, has helped it maintain a respectable level of profits — despite fluctuations in growth rates — and return on shareholder funds.

Sirpur Paper now plans to set up a new mill, which would expand its capacity by about 60 per cent to 1.3 lakh tonnes.

Its investment plans are likely to lead to higher operating efficiencies, compliance with stringent environment norms, superior product mix and flexibility in using a variety of raw materials.

The company plans to bankroll 55 per cent of the project cost of about Rs 300 crore using debt. Despite sourcing debt funds at attractive rates, the interest cost could go up and affect the earnings stream. This may be neutralised to an extent by a drop in the tax outgo.

A key factor would be the state of the paper price cycle when the project is commissioned (due date is September 2006); especially, trends in 2007 and 2008 would be crucial, as the new capacities are likely to be operated at full throttle only in FY-08.

Over the past decade, any upward trend in paper prices has been compressed in short periods and followed by a protracted period of sluggishness with significant downside at the international level.

If the paper price cycle is unfavourable at the international level in 2007-08, it could lengthen the payback period for the expansion project of Sirpur Paper. This risk, too, makes the offer unattractive.

In terms of domestic demand-supply, the situation is likely to be favourable to producers when the expanded capacity goes on stream. But this may not confer any pricing power, as international trends would play a key role.

Offer details: The rights offer is at a ratio of four shares for every five held. The equity base would rise from Rs 8.3 crore to Rs 15.0 crore.

The lead manager is IL&FS Investmart. The rights offer closes on April 21. The amount payable on application is Rs 36; Rs 54 would be payable on call.

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