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Sunday, Nov 27, 2005

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Finolex Industries: Buy

Alagappan Arunachalam

INVESTORS may consider taking exposures in the stock of Finolex Industries. At Rs 80 the stock quotes at 19 times its trailing 12-month earnings. The valuations would be lower if one considers the market value of investments in its group company — Finolex Cables. A steep rise in raw material prices and lower realisations from PVC resins have driven down earnings during the first half of FY 06. However, there is potential for a turnaround, as there is a reversal in price trends in the second half. An expansion of its PVC resins facility would help it tap the growing resins market.

Finolex Industries is among the larger manufacturers of PVC pipes. Finolex has an advantage over other PVC pipe manufacturers in India, as it is the only large-scale vertically integrated facility. Its backward integration into PVC resins helps Finolex Industries protect margins compared to non-integrated players. The PVC resins division contributes about 65 per cent of the revenues. Its pipes and fittings division accounts 25 per cent. Treasury operations contribute about 10 per cent of earnings.

The PVC pipes industry depends on the agricultural and urban infrastructure sectors. Despite slow growth in the agricultural sector, Finolex was able to grow by 8 per cent in volume in PVC pipes during FY-05. An increasing focus on irrigation projects both by Central and State governments and the intense activity in the realty sector would help in sustaining the growth rate. There has been a capacity constraint at the PVC division, which has held the company back from exploiting the revenue potential. Finolex seeks to set this right by expanding its resins capacity by 100 per cent, taking it to 2.6-lakh tonnes per annum. The expansion project is scheduled to be complete by the end of FY 06; this is funded by debt. The domestic demand for PVC resins is expected to grow at 7 per cent over the next three-five years.

Raw materials account for about 50 per cent of production costs. A 15 per cent rise in the cost of ethylene dichloride (EDC) in the first half of FY-06 and a similar rise in ethylene have impacted its operating margin. The fall in PVC resin realisations accompanied by lower volumes appear to have caused a 24 per cent decline in revenues. A 50 per cent fall in operating profits coupled with a higher interest outgo brought down earnings significantly.

However, there is potential for a turnaround as increased investment in irrigation infrastructure could pep up off-take from the agricultural sector. Costs of EDC and ethylene are expected to soften as crude oil prices have cooled off. The price of PVS resins, the end product, is also on a recovery path. Finolex Industries could post better margins in the second half of FY 06. Higher volumes from the expanded capacity combined with better profit margins, point to strong earnings growth.

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