The Hindu Business Line : ABG Shipyard: Invest at cut-off

INVESTORS can bid at the cut off price in the initial public offer of ABG Shipyard, as it holds promise of gains over a one-two year period linked to fundamentals. The offer is priced in the Rs 155-185 band.

We believe that the pricing is attractive and leaves headroom for gains; if the final pricing is done closer to the lower end of the band, it will offer investors a high degree of comfort, even if the broad market moves into choppy territory.

Our recommendation does not factor gains on listing. The principal risk to our recommendation is a change in fiscal policy that cuts incentives now available for ship-builders. Our recommendation is underpinned by the following factors:

ABG Shipyard has a healthy order-book position that should comfortably take care of revenues over the next couple years, accompanied by robust growth. This provides a high degree of clarity to earnings.

The company also has a diversified order-book straddling domestic and overseas buyers and this, too, augurs well for its growth prospects. Exports, as a percentage of revenues, have declined over the past three years due to buoyancy in orders from domestic buyers; it is, however, likely to stabilise at a level where it contributes at least half the revenues.

The client base also reflects a high degree of diversification with buyers straddling several user industries. This trend, too, is a positive from a long-term perspective.

ABG Shipyard has scaled up its operations over the past couple of years, as the order book has swelled. We expect healthy growth on the high base, as has been the case so far this year. This trend has also been helped by the fiscal incentives received from the government, which have led to an expansion in profitability levels. This is likely to be a factor in ramping up revenues and earnings over the next couple of years, too.

There is also the likelihood of a further expansion in order book for small- and mid-sized ships for players such as ABG Shipyard, as the traditional bigwigs in shipbuilding in countries such as South Korea and Japan are booked through FY-09. The latter has been a factor in the spurt in order-book for companies such as ABG Shipyard and Bharati Shipyard, to name a couple, and is likely to remain a key driver of growth. Smaller shipbuilders in countries such as China, India and Brazil appear to have a cost advantage in this space.

ABG Shipyard plans to set up a new shipyard at Dahej in Gujarat. Apart from enhancing its capacities, this new facility will also provide the company with the flexibility to make a wider variety of ships and strengthen its ability to attract more orders from the domestic and overseas markets.

It is likely to make a contribution to revenues only from FY-09 onwards, and to earnings only subsequently. This big-ticket investment is, however, unlikely to serve as a drag on growth over the next couple of years.

ABG Shipyard plans to bankroll its capacity expansion through a combination of debt and equity. A part of the equity expansion is likely to be used to finance working-capital requirements.

The equity base will expand by less than 20 per cent; the earnings growth from its existing order-book should compensate for this expansion and increase due to the private placement with strategic financial investors.

We also take a positive view of the company's decision to refrain from dividend payments, as it has been in an investment mode.

The pricing of the offer may not appear as attractive as that of the IPO of Bharati Shipyard last year; if one takes into account the difference in the scale of operations and a superior story on key operational and financial parameters, the pricing does leave scope for appreciation.

It is also at a considerably lower valuation compared to what is enjoyed by the Bharati Shipyard stock now; this, too, provides comfort, as there is no reason why ABG Shipyard should trade at a sizeable discount to Bharati Shipyard.

We also believe that stocks in this space are likely to attract the support of institutional investors. Institutional investors hold about 25 per cent of the equity of ABG Shipyard and as it gets broad-based, it will augur well for price discovery and the emergence of a sustainable valuation level.

The principal risks to our recommendation are:

The fiscal incentive to shipbuilders is available for a five-year period that ends in August 2007. If this is not extended, it could lead to a sizeable decline in earnings of ABG Shipyard, which has benefited immensely from the subsidy over the past 18 months. Even if the government decides to extend this facility, there could be delays in giving effect to such a decision. As India is gradually acquiring strength in the shipbuilding space, there is the distinct possibility that the incentives may be extended for a longer period. If the policy is overturned, we will review our stance on the stock. At present, we do not believe that the risks on this score could detract from the valuation that the stock may command.

When the new shipyard commences operations at the global level, there could be a freeing up of capacities, as the now-burgeoning order-book is exhausted; most of the fleet on order now is due for delivery over the next three years.

If a high degree of slack in new orders emerges, this may act to the detriment of ABG Shipyard and the payback period for the new project could get extended.

ABG Shipyard's business is noted for the high degree of working capital intensity. In this context, the plan to augment the financing through the offer is a positive. Any deterioration in the quality of working capital management has the potential to act as a drag on profitability.

Offer details: ABG Shipyard is offering 8.5 million shares through this book-building offer. The offer opens on November 18 and closes on November 25.

The book-running lead managers are IL&FS Investmart and ICICI Securities. The equity base will be Rs 50.9 crore on completion of the offer.

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