Pipavav Shipyard IPO Analysis

Investors with a low risk appetite can give the initial public offer (IPO) of shipbuilder Pipavav Shipyard a miss; the offer does not appear to be a compelling investment option at this point in time given the lack of an operational track record, relatively attractive valuations of listed peers, pricing pressures and risks of vessel order cancellations.
The shipbuilding sector is reeling under stress as a result of the downturn, with no clear signs of revival in orders.
The offer is being made at a price band of Rs 55-60; the price discounts the estimated per share earnings for FY-11 by about 18-20 times. This is at a steep premium to the listed peers ABG Shipyard and Bharati Shipyard that are currently trading at single-digit valuations.
While a premium to peers may be justified given Pipavav’s superior dock facility and multi-product capabilities, the premium demanded may not be warranted at this stage for the following reasons: One, shipyard is a sector with high cyclical risks and has traditionally traded at a discount to the broad market. Two, lack of operational track record and execution risks associated with Pipavav makes the pricing appear even more stiff at this stage. On an enterprise value to order book ratio too (as revenue is yet to flow), Pipavav is at 1.1, stiffer than the 0.3-0.4 times ratio of its peers. Earnings may however ramp up quickly post FY-11 when a good number of the vessels contracted now are completed.
The shipbuilding business of Pipavav Shipyard, no doubt, holds huge long-term potential, given the company’s well-integrated facility comprising docks, fabrication and block assembly as well as facilities for offshore products.
Business opportunity flowing from the co-promoter Punj Lloyd may also prove to be an added benefit. Investors can therefore wait out the IPO and look at buying the stock in the secondary market at a later date, when a lower price or a year or two of sustained financial performance, make the stock a more attractive investment.
The company and offer
Pipavav Shipyard is a shipbuilder with infrastructure facility to build commercial and defence vessels as well as fabricate and construct offshore rigs, platforms and vessels. With a dock capable of accommodating ships of up to 4,00,000 dead weight tonnage (DWT is the weight a ship can carry safely), the company claims to run the largest dockyard in India (on full completion).
The company commenced its commercial production only on April 1 this year and is at present building four vessels which it seeks to deliver by April 2010. It hopes to raise Rs 470-512 crore from the current offer, which would expand its existing capital by 15 per cent. A good part of the proceeds would be utilised towards working capital requirement and the rest towards capital expenses.
Huge order book but…
Pipavav has about Rs 3,800 crore of total orders in hand (excluding orders of Rs 689 crore under arbitration), including ONGC’s order of Rs 535 crore for offshore vessels.
While shipyard orders have dwindled in the recent downturn, most Indian shipyards have managed their business without facing cancellations.
Note that shipping orders are often subject to cancellations. Ship orders typically rise on the back of increasing freight rates or oil prices. However, given that the time lag between receiving a contract and delivery ranges between 22 and 45 months depending in the size of the carrier, the cycle of freight rates or oil prices may reverse, thus leading to order cancellations. Downward revision in price of vessels and insertion of clauses by clients to opt out of the contract are common.
Pipavav, too, is not devoid of these risks. For instance, of the Rs 3,800 crore of orders mentioned, the company is in discussion with a client to amend agreements for about Rs 1,105 crore of orders.
The client has sought unilateral rights after a certain date to terminate its obligation to take delivery of vessels if it is unable to arrange for funding for the vessels. The company is also engaged in arbitration for some orders to determine whether the customer has the right to cancel such orders.
These uncertainties leave about Rs 1,800 crore of firm orders in hand effectively. While all the above orders may yet sail through, revision of key commercial terms, such as price of vessel, options exercisable at the customer’s discretion and unilateral rights to terminate obligation to take delivery, pose huge risks to certainty in revenue flows for the company. Note that the company has already delayed delivery of two vessels.
This said, the uncertainty factor in defence vessels, for which the company has just bid, may be much lesser. While there are no orders from this segment at present, a ramp up in this segment could reduce the risk otherwise inherent in this sector. Further, that co-promoter Punj Lloyd has agreed to conduct offshore activities in India through Pipavav may provide some diversification in the product mix of the latter, thus mitigating risks.
Pipavav did not have any revenues until March 2009, pending commercial production. The company would have to deliver 10 Panamax vessels totally valued at Rs 1,788 crore between April 2010 and May 2012. This, together with the execution of the ONGC orders, would be the key sources of revenue over the next couple of years. Receivables from one of the carriers are, however, assigned to a bank. This could reduce cash flows.
As the company would have capitalised over Rs 2,000 crore of assets post March 2009, depreciation, pending revenue flows, would dent profits in the initial quarters. Interest cost of about Rs 90 crore paid in FY-09 is unlikely to reduce significantly, given that the facility has only been recently commissioned.
These factors could drag profits for the next 4-6 quarters. Pipavav’s key advantage would be the tax-free status of its SEZ fabrication facility (leased by subsidiary) and lower taxes for the shipyard, being an export-oriented undertaking. This is likely to ensure superior net profit margins for the company, even as the industry currently enjoys about 12-15 per cent. This status may nevertheless change post the implementation of the Direct Taxes Code.
Macro advantage, no longer
The Indian shipyard industry had the advantage of copious order flows in 2007 and up to mid-2008 as a result of the traditional shipbuilding countries of Korea, Japan and China being booked fully. India’s cost advantage, together with the subsidy provided by the Government for orders up to August 2007, have all aided order flows.
Going forward, the capacities of the above nations are likely to be freed up, given the downturn, thus intensifying competition for Indian players. Importantly, the 30 per cent incentive on shipping contracts provided by the Government has not been renewed so far. These factors may pose a challenge for the Indian players.
The offer is open from September 16-18.
via BL