Turnaround Candidates

In a market that has been seen sustaining its own well above the psychological 18,000 level, there aren’t many who would like to alter their investment philosophies. Sticking to fundamentally strong counters would be a thumb rule here as many would tend to prefer steady returns. But what if one is not satisfied with just steady returns and wants to make the most of this scenario even at a level when the valuations seem to be getting steep as the market marches ahead? A Roman poet Virgil once said, ‘Fortune favours the brave’, implying thereby that luck is usually on the side of those who take risks. The point we want to drive home here is that the odd route isn’t easy and many would question the sanctity of it, but the end rewards are much better.

Thus, in stock market parlance it would mean one has to go against the herd and focus on loss-making companies. Shocking as it may sound, the idea is to hunt for scrips that are out of favour of the investor fraternity due to their current losses, whose value is not reflected in prices but at the same time have the potential for a turnaround to catch investors’ fancy sooner or later.

We at Dalal Street Investment Journal (DSIJ) too believe in this theory and have been conducting this annual exercise under the title ‘Turnaround Candidates’ over the years. The basic idea of this exercise is to follow a methodical way of ferreting out those hidden gems in a host of loss-making companies, who have been trying their best to put wind into their sails and reach the land of profit. But the one question that many might ask is this: Is it necessary to indulge in such an exercise? Our answer to this would be an astounding ‘yes’. There are reasons why we will feel that it is important to take this effort considering that investors will stand to benefit over a long-term period. First and foremost, it has been witnessed that turnaround candidates seem to outperform the broader markets and tend to provide better returns. As proof of our argument, consider the fact that our turnaround candidates for FY08 posted an overall appreciation of 44 per cent compared to a mere 3 per cent by the Sensex within one year’s time and this performance was further boosted in FY09 when they yielded average returns of 61 per cent compared to the Sensex’ gain of just 16 per cent.

Similar has been our experience even in the earlier years. This clearly goes to show the inherent strength of these scrips. Secondly, considering the beaten-down levels of these stocks, these scrips are available at very good valuations, which means that the worst is already discounted in the price and they can only move upward from here on. Besides, even if the market corrects for some reason, the downside will remain limited in view of the fact that they are already beaten down, thereby limiting capital erosion. Third, determined as they are to get[PAGE BREAK]

on to the profit path, the management of these companies are quite upbeat, high on innovation, and constantly thinking out of the box to drive their future growth both in terms of topline and bottomline. And when the results of these motivating factors begin to get reflected in the results, the scrips begin to perform better on the bourses as they attract the fancy of the investors.

That apart, another interesting fact witnessed over the years is that the number of loss-making companies has been declining drastically since 2004. As on FY10, this number fell to just 90 companies from as high as 1,082 companies in 2004 or just over 8 per cent compared to the 2004 figure (refer table on previous page.) Even over the last fiscal itself the drop has been as high as 48 per cent. While there is good reduction in loss-making companies in Group B and T, what’s even astonishing is to see a sharp reduction in the number of loss-making companies in Group Z to just 2 from 477 companies seen in 2004. This clearly shows that economic activity is picking up and companies across the board are striving hard to drive their growth. In contrast to this happy state of affairs, the number of companies in Group S has risen to 11 in FY10 as compared to 7 in FY09.

Automobile Corporation Of Goa - Picking Up Speed
Automobile Corporation of Goa (ACGL), which manufactures bus bodies, is a perfect example of how a series of events can push a profit-making company to posting losses in FY10. It all started from the quarter of December 2008 when the sales volume started declining and so did the topline and bottomline of the company. The reason behind the same was quite simple - global recession. With the global economy reeling under an unprecedented crisis, the demand for commercial passenger vehicles dipped low and hence volumes got impacted, more so since ACGL used to earn major revenues from exports. The worst part was that the realisations started declining too and in June 2009 the company’s sales volume touched its trough with a loss of Rs 3.97 crore.

Then things started to improve from September 2009 as the demand from domestic markets started to pick up.  But again realisations were low and despite an increase in topline the rising raw material cost resulted in loss Rs 7.29 crore for the September 2009 quarter. However, the scenario got better in December 2009 as the demand started to pick up from the exports markets too. But in the quarter of March 2010 the management faced a labour problem and could not take advantage of the rising demand. So with only 2,373 units sold in FY10 as compared to 4,509 in FY09, ACGL posted a loss of Rs 2.14 crore. In our opinion, the worst is over for the company and the future seems to be bright. The first and foremost factor is the[PAGE BREAK]

increasing demand from exports markets such as the Middle East and South Africa. Meanwhile, realisations have gone up too. This has been clearly visible in Q1FY11 wherein the EBITDA margins have improved sharply. Further, the company has been successful in get-ting bulk orders from the state and city transport undertakings for buses and aims to increase the volumes in these segments during the rest of FY11. As regards its financial performance, the Q1FY topline was Rs 7,809 crore and bottomline was Rs 3.20 crore. Going ahead, with increased volumes and better realisation we expect the company to post improved results in FY11. We expect an EPS of Rs 27 for FY11 and therefore our recommendation to investors is to buy the scrip with a target price of Rs 500 in the next one year.

Patspin India - A Positive Spin
There are some companies that fail to perform due to factors internal to the organisation, while there are some who despite the potential fall prey to external factors. Patspin India belongs to the latter and has been posting losses since FY08 through FY10. Part of the GTN Group, Patspin is into the manufacturing and selling of cotton yarns in the export and domestic markets. More than 70 per cent of its revenues are derived from exports to Europe, Japan, and Korea and the balance from the domestic sector. It was a chain of events that led to the company slipping into losses. After executing a massive Rs 273-crore expansion for doubling its capacities in FY07 which was primarily financed by debt, the company’s production was hit by massive power cuts ranging from 30 per cent in Kerala to 50 per cent in Tamil Nadu, thereby leading to under-utilisation of its capacities.

Besides, with the recessionary forces sweeping through global economies, the company’s export trade took a severe hit. With demand remaining low, the realisations continued to dip and the higher cost of procuring raw material impacted the margins further. Besides, with the company’s production being curtailed due to power cuts and lack of demand, it could not fully utilise the forward exchange contracts, which had to be cancelled resulting into losses. But that’s in the past and we believe that with the revival of the textile sector and the emergence of demand both on the domestic and export front, things certainly are looking bright.

The management has undertaken several initiatives such as restructuring of debt, capital infusion by promoters, early completion of projects, curtailing capital expenditure, arranging power supply commitment from private players (leading to increased capacity utilisation), and so on. Also, with the demand improving steadily, volumes and realisations too have begun to pick up and this will give the much-needed fillip to the company’s revenues and margins. With its debts realigned at concessional rates, the interest cost will come down and lead to further margin expansion. All this should help Patspin post profits of around Rs 10-11 crore in FY11, thereby resulting in PE of mere 4x. It would be worth grabbing it then at its current levels with a one year target of Rs 20.44.[PAGE BREAK]

Uniply Industries - Gaining In Strength
Unilply Industries (UIL) is a Chennai-based company engaged in the manufacturing and marketing of plywood and allied products. Besides, it was also involved in the wind mill business till the last fiscal. This contributed less than 2 per cent of the entire revenue for the last fiscal. When we analyse the losses posted by the company, before taxation, in the extraordinary item and interest category we find that more 92 per cent of the loss has been borne by the wind mill division. Now, from the cur-rent fiscal, the management has decided to discontinue this business and has sold it to a group company of a vendor.

The result of this decision has been clearly reflected in the results of the first quarter of FY11 wherein the company has returned to black and posted profit of Rs 0.85 crore as against loss of Rs 1.33 crore in the last year same quarter. But it’s not only the bottomline that is improving. Even sales have increased in the latest quarter by 32 per cent on a yearly basis and have increased from Rs 18.4 crore (Q1FY10) to Rs 24.2 crore (Q1FY11). One of the reasons for such an increase is the pick-up in the real estate sector, both commercial as well as residential. UIL has some of the best corporate clientele that includes banks like SBI, ICICI and companies such as IBM, Airtel, etc.

To further improve the scenario, the company has launched more than 100 varieties of decorative wood veneers under the brand name ‘Elementz’ which, according to the management, will materially affect the turnover and the profitability of the company going forward. Even the balance sheet has been gaining in strength and over the last three years it has reduced its debt from Rs 57.04 crore in FY08 to Rs 47.69 crore in FY10. Going forward we believe that the action taken by management will yield benefits and so will the improving economic climate and the fresh investments by the corporate sector in new offices. Our suggestion is that it would be worth the while to invest in this counter.[PAGE BREAK]

Pacific Cotspin - Beefing Up Operations
Pacific Cotspin (PCL) is a Kolkata-based textile company promoted by Ashok Mehra and C P Mehra as a 100 per cent EOU. The plant has an installed capacity of 30,000 spindles for 16 metric tonnes of production. The company is going through a phase of expansion and plans to add 12,000 spindles to increase the capacity to 42,000 spindles. The expanded facility will be used to manufacture value-added products like special and compact yarns. PCL is mainly focused on products such as internationally accepted cotton yarn of both combed and carded qualities from counts of 20 to 60 counts, contamination-free cotton yarn of all counts and qualities, and organic cotton yarn for high-end users.

As regards the financials of the company, its topline has witnessed a stellar growth of 149 per cent for the first quarter ended June 2010 and was Rs 40.47 crore as against Rs 16.28 crore for the same period last year. If we analyse the financials on a quarterly basis, it is observed that the company has turned into black on an operating level in Q2FY10 and has been able to remain in black since then. The operating profit was Rs 1.47 crore for Q1FY11 as against a loss of Rs 0.99 crore for Q1FY10. The operating margin has seen an improvement and presently is 3.64 per cent for Q1FY11. The only deterrent factor is that the debt to equity ratio is on a higher side at 2.22x. The company is likely to witness more volumes in FY11 and this will negate the effects of the higher interest cost.

Indo Tech Transformers - Pumping Up The Power
Indo Tech Transformers (ITTL) is one of the prominent players in the Indian electrical industry for power & distribution transformers and various special application transformers. It has four manufacturing facilities spread between Kerala and Tamil Nadu. On the inancial front, the company has witnessed subdued performance for fiscal 2010 and its topline was Rs 101 crore, witnessing de-growth of 52 per cent on a YoY basis. The company posted loss of Rs 8 crore in FY10 as against profit of Rs 38 crore in FY09.

In May 2009 GE Prolec acquired 79 per cent stake in the company. On the positive side, there is a definite momentum in the order inflow. ITTL has received orders to the tune of Rs 45-50 crore in Q1FY11 as against the order inflow of Rs 65 crore during the whole of FY10. We believe this was the single most important issue for ITTL since there virtually was no inflow during the past four quarters. Other things like quality of product, pre-qualification, and range of transformers are not likely to be an issue since it’s a subsidiary of GE-Prolec now. With the orders coming in, we expect significant improvement in numbers from H2FY11 onwards. And that is what makes it an ideal turnaround candidate for FY11.