Orient Abrasives: Opportunistic Investment Opportunity

Introduction:

Orient Abrasives Ltd is India’s largest manufacturers and exporters of bauxite based High Alumina Synthetic Raw Materials like Brown Fused Alumina, White Fused Alumina, Pink Fused Alumina, White Fused Mullite, Calcined Bauxite, High Alumina Refractory Cement, Zirconia Mullite, Almag (Spinnel) for grinding wheel manufacturers (Vitrified, Resinoid & Coated Products) and refractory manufacturers, also Grinding wheel and Castable Refractory for steel & cement plants. The company has carved itself a storng niche within the overall abrasives and grinding wheel market. As per the company, it has 70% market share in fused aluminium oxide grains, 64% in calcined products and 20% in monolithics.

Business:

The company has three business segments: Abrasive Grains, Bonded Abrasive, and Refractories.

Abrasive Grains: This business manufactures calcined bauxite and aluminium oxide abrasive grains which are important raw materials for refractories used by the steel industry. A portion of this business’s production is captively consumed by the Refractories business.

Bonded Abrasive: Bonded Abrasives are commonly called grinding wheels since they are generally in the shape of wheels that are used for grinding, finishing, honing, polishing etc. Major user industries for this product are automobiles, bearings, cutting tools, steel etc.

Refractories: This business manufactures various types of continuous casting and slide gate retries, low cement castables etc. which are exclusively consumed in the steel plants. The Refractory Division also exports its products to Egypt, Turkey, Indonesia and some European countries.

Industry:

The organized abrasives and grinding wheels market in India is quite an oligopolistic market with four major listed players: Carborundum Universal, Grindwell Norton, Orient Abrasives, and Wendt India. Nevertheless, there are several smaller players who specialize in specific products. The industry is characterized by diverse user industries, an insignificant threat from substitute products, and adequate raw material availability.

The industry has been going through a purple patch mainly on account of good demand from user industries, which has resulted into strong demand for products of companies in this sector. The industry mainly craters to Auto-OEM and Auto ancillaries, General engineering (capital goods), Construction and fabrication, Steel, Bearing etc. Increasing infrastructure activity, booming construction and a flourishing economy in India together have bolstered the revenues of abrasives and grinding wheel sector.

Initiatives:

Orient Abrasives has decided to install a thermal power plant (lignite/pet coke/coal based) at a cost of about INR 340 million at its Porbander works to save on energy costs. The plant is likely to be commissioned by the middle of the year 2007. In the process, the company will considerably save on fuel costs, as lignite / pet coke / coal costs are much cheaper than furnace oil, which is consumed by the existing power plant. The project will be financed partly by internal accruals and partly by term loan from institutions / banks.

Outlook:

With new investments budding roses in Indian industries and with increased outsourcing by Western markets from China and India, the abrasives and grinding wheel sector is expected to witness continued strong demand growth. In the coming years, the user industries for the company’s products, Steel and Engineering Industries, are expected to perform well. The steel industry, which is the largest consumer of the company’s products, is expected to increase its capacity by 50% over the next five years. There is supply shortage in the steel industry. Expansion by the steel industry coupled with the consumption growth places Orient Abrasives on track for a volume growth of 12-13% on the domestic front. As the company is making an increased push to enter the exports market, it should only result in stronger growth for the company.

Concerns:

The company had to suspend production at its Porbander plant w.e.f. February 21, 2006 in view of the directive of the Gujarat Pollution Control Board issued under section 31 - A of the Air (Prevention and Control of Pollution) Act, 1981. The Company has already moved the Hon'ble High Court, Gujarat for resumption of production.

Valuation:

As discussed earlier, the increased demand by the user industry bodes well for the company and places the on track to record high double digit growth in revenues and earnings. Further, the company’s thrust on exports is paying off. For the year ending March 2005, the company can report sales and net profit of INR 1650 million and INR 195 million, giving an EPS of INR 3.2. The current market price of INR 28 discounts this EPS just 8.8 times. Also, the company is quoting at a significant discount to it peer group, approximately 50% discount. Most of this discount appears to be unwarranted. Using a mix of historical multiple, relative valuations and the DCF, we arrive at a price target of INR 45 for the stock with a time frame of one year. One good indication of stocks deep value is the fact that the promoters have been increasing their stake after the recent decline in the stock’s price.