Essar Ports: HOLD

Investors with a two- to three-year perspective can continue to hold shares of Essar Ports. As the second largest private port operator in the country next to Mundra Port and SEZ, this newly listed entity with a 83.7 per cent promoter holding derives high revenue visibility from the take-or-pay contracts with group companies. Ongoing expansion of ports also provides scope for improving third-party revenue streams.

At the current market price of Rs 54, the stock trades at 19 times its expected per share earnings for FY-12. The valuation is at a steep discount to Mundra Port & SEZ (25 times expected FY-12 earnings) and may remain so until revenues from higher capacities kick-in.

Investors can view the stock as a high-risk high-return bet, given that the port is in a growth phase. High level of debt as a result of capital expenditure incurred for projects currently under execution and dependence on group companies for revenue, make it a riskier bet compared with Mundra. Diversification of the revenue stream and completion of the current expansion phase would be the triggers to watch before investors take fresh exposures in the stock.

Background

Essar Ports came in to existence following the demerger of Essar Shipping Ports & Logistics in to listed entities Essar Ports and Essar Shipping. The port division's high growth trajectory appears to have prompted the group to house the business in a separate entity. This would not only help the group focus better on the lucrative business but also leverage on its own balance sheet.

For every three shares held in the erstwhile listed entity, investors would have received two shares of Essar Ports and one share of Essar Shipping.

Essar Ports has a gross cargo handling capacity of 88 million tonnes per annum (MTPA) as against Mundra's 115 MTPA. The company has two operating ports on the west coast, with its group companies, Essar Steel, Essar Power and Essar Oil being the anchor clients. Crude, liquid products and intermediates accounted for 75 per cent of the total volume for the June 2011 quarter. Its expansion plans would take the capacity to 158 MTPA in phases, over the next couple of years, adding one more port on the west coast and two bulk terminals on the east coast.

The company derives almost all of its revenue from its group companies. This makes the port a captive play currently. While Mundra Port too, derives substantial revenue from its anchor client and group company Adani Enterprises, it has key third-party clients such as IOC or Maruti Suzuki India besides stakes in an Australian port.

This concentrated and inter-group revenue stream thus makes Essar Ports a relatively riskier play. However, it needs to be mentioned that the company is attempting to make up for the above risk by seeking higher returns from these revenue streams.

For one, it has tied-up a significant portion of its capacities, both under operation and under construction through long-term take-or-pay agreements with the other Essar companies. This would entail clients paying up for an assured capacity level or actual capacity utilised, whichever is higher. Such a deal can significantly mitigate risks arising out of volatility in port traffic. After recent capacity additions in Vadinar, revenues from the minimum guaranteed take-or-pay income accounted for 80 per cent of revenue in the latest ended June quarter, as against 60 per cent a year ago thus providing assurance of a regular income stream.

Two, the company has also hiked tariffs levied on group companies, thus boosting profitability. Average realisation for a tonne improved from Rs 173 in FY-11 to Rs 220 in the June quarter of current fiscal.

The company has built-in escalation clauses in its agreements to ensure that rates are periodically revised. These measures, to some extent, relieve concerns about related-party transactions and ability to maintain arm's length dealings.

Three, the off take agreements have not made the company complacent about traffic volumes which expanded at a healthy 14 per cent in the quarter ending June 2011 over a year ago. The 70 MTPA capacity additions expected over the next two years would boost volumes; given that it is directly linked to the group companies' ongoing respective capacity additions. Efforts to ramp up revenue from non-group traffic volume, which is negligible at present, may also yield results, given the strategic location of the ports and the burdened capacities of all major ports in the region. Larsen & Toubro, Torrent Power and Bhatia International are some of the non-group clients at present.

While the above combination of a steady revenue stream and improved volumes from third parties support prospects, Essar Ports faces the risk of delay in completion of its expansion programme. Its Salaya Coal terminal for instance is delayed by 12 months while the Paradip Coal terminal has overrun its schedule by six months.

The huge debt sunk in to these projects have kept the debt equity levels at an elevated 2 times. Revenue flow would be crucial to service the debt.

Financials

For FY-11, the ports division of the erstwhile company clocked revenue of Rs 706 crore while segment operating profits was Rs 368 crore. The latest ended June quarter saw revenue growth of 61 per cent to Rs 278 crore over a year ago, while net profits jumped 11 fold to Rs 39.5 crore.

EBITDA margin rose to 79 per cent (versus 73 per cent a year ago) and is comparable with Mundra Port. Return on equity, though is likely to just touch the two-digit mark in FY-12, far lower than Mundra's 20-25 per cent returns. This can improve only on higher capacity coming on stream.

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