The Hindu Business Line : Gati: Hold

The prospects for the logistics sector continue to hold out promise. However, we would prefer to adopt a conservative stance in the case of Gati against the backdrop of a significant equity expansion.

Growth trends remain strong
Shipping division posted sharp margin improvement
Equity expansion may limit earnings growth

WITH MARGINS rising, Gati's shipping business has turned out to be a surprise package.

Investors can retain their holdings in the Gati stock, which trades at about Rs 75. We have a `buy' recommendation outstanding on the stock and continue to maintain that the growth prospects for the logistics industry, in general, and Gati, in particular, remain bright. The stock did gain over 50 per cent since our recommendation, before falling sharply, as the market capitulated in May.

Our current view, however, is driven by the significant expansion in the company's equity in the recent past. This will get enhanced further if the foreign currency convertible bond (FCCB) issue is put through this fiscal. This expansion would keep earnings growth under check. Given the expectation level built into the stock — it trades at about 18 times its expected per share earnings for the year ending June 2007 (excluding dilution on account of the FCCB issue) — we reckon there would be little street tolerance to any disappointment on the earnings front. We would, therefore, remain circumspect at this juncture and observe Gati's performance over the next quarter or two, before considering a recommendation upgrade.

Financial performance

Margins for the year ending June 2006 in the express distribution business (25 per cent year-on-year revenue growth) remained at the same levels as those of the year-ago period (9.7 per cent). Though margins dipped marginally in the last quarter, we believe they should get back on track in the ensuing quarters as price hikes to offset rising fuel costs are passed on to customers.

The shipping business (80 per cent y-o-y revenue growth) turned out to be the surprise package with margins rising an impressive 10 percentage points to 19 per cent for the whole year. The fuel stations business (14 per cent y-o-y revenue growth), which makes a marginal contribution to earnings, displayed flat margin trends. We note that this business would be transferred to four wholly-owned subsidiaries.

On the whole, sustainable earnings almost doubled to Rs 20 crore; diluted per-share earning stood at Rs 2.8.

Prospects

With economic growth likely to remain good, the prospects for the logistics sector are encouraging. The massive investments in roads, ports and airports should spur the industry's growth. Being a leading player, we expect Gati to be among the principal beneficiaries if there is an improvement in India's infrastructure.

With a footprint that covers all but eight districts of the country, there is limited headroom for significant geographical expansion. Growth should come from higher volumes and cost-efficiencies. Given the positive trends in user industries such as IT, telecom and retail, the growth drivers appear to be in place.

Gati is making significant investments in its warehousing facilities and information technology. Towards this end, it raised funds through a rights issue last year, apart from a preferential allotment and an issue of warrants to AMP Capital Investors. An FCCB issue is also on the cards. We believe that the investments planned by the company will reinforce Gati's industry standing, widen its service offerings and give it a better handle on costs. However, the benefits of such an investment exercise, in our view, are likely to flow in over the medium term.

In a rising fuel price environment, Gati should be able to pass on hikes to customers, as airline companies do to counter escalating input costs. However, should fuel prices continue to march upwards unabated, the key issue to watch out would be the extent to which it leads to a demand cool off and its impact on earnings.

Prospects for the shipping division are also likely to improve once Gati's proposed acquisition of another vessel (which may be operational next fiscal) to link Chennai with Thailand happens. This could receive a boost from the free trade agreement that India has with Thailand. However, in the event of a slump in trade, the shipping division could be saddled with high fixed costs that could act as a drag on overall earnings.

Finally, the spectre of consolidation in the logistics industry cannot be ruled out. Most global players are already here and once the scramble for scale intensifies, consolidation may well be inescapable. Should Gati be part of such an exercise, the stock could see some zip, though we would not recommend buying on that assumption.

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