NDB Stockbrokers recommend Laugfs Gas IPO as ‘Buy’

NDB Stockbrokers is recommending the Initial Public Offering (IPO) of Laugfs Gas as “Buy.”

The IPO worth Rs. 2.5 billion is currently up for subscription whilst its official opening is on November 4th. Here are excerpts from the NDB Stockbrokers preview on Laugfs IPO.

Initial Public Offer

The company would be listed on the Diri Savi Board of the Colombo Stock Exchange subsequent to the Initial Public Offer. The minimum subscription per application is 100 shares for any class of shares, while applications exceeding minimum subscription should be in multiples of 100 shares.

Applications can be made for either class of shares or in combination of both classes of shares.

The allotment of the shares will be as follows. Laugfs Gas Ltd (LGL) is engaged in the business of import, storage and distribution of Liquefied Petroleum Gas (LPG) and related products in Sri Lanka.

Laugfs Eco Sri (Pvt) Ltd (LEL), Laugfs Leisure Ltd (LLL) and Laugfs Property Developers (Pvt) Ltd (LPDL) are subsidiary companies of LGL which are in the business of operating vehicle emission testing centers, hotel management and property development respectively.

Industry

Liquefied Petroleum Gas Industry

LPG industry has experienced continuous growth as a prominent source of energy. Shell Gas Lanka Ltd dominated the market for a period of 5 years. The industry was liberalized in 2001 with the entrance of Laugfs to the market.

Bulk of the LPG requirement is imported to the country and stored and distributed by Shell and Laugfs. Laugfs transports imported gas using road transport to the storage facility in Mabima while Shell uses a pipe based transport system which is less costly.

The industry operates under strict safety and price regulations. Pricing is governed by the Consumer Affairs Authority where the prices are linked to the world market prices and a margin is allowed on the landed cost. Laugfs is allowed a margin of 30% on the landed cost while Shell is allowed a margin lower than that.

At present, prices are revised every 2 months. Under the safety standards refilling of cylinders by a third party is not allowed. According to the prospectus only 25% of households use LPG as a fuel for cooking purposes. Therefore the industry has high growth potential. Opening of the North East region and the growth in tourism are also expected to boost demand.

Leisure Industry

With the recovery of the tourism industry in Sri Lanka, we expect the tourist arrivals to approach 600,000 in 2010 (up approximately 34% YOY). Further, according to the Tourism Ministry of Sri Lanka, plans are underway to increase tourist arrivals to 2.5Mn by 2016.

Property Development Industry

Sri Lanka property sector was stagnant over the last 3 years. However we expect the property sector (and prices) to appreciate rapidly in the coming years with the growth in demand.

Company

Today Laugfs enjoy a 28% market share in the overall LPG business. Majority of the LPG requirement of LGL is imported while approximately 30% of its requirement is sourced from the Ceylon Petroleum Corporation (CPC). LGL purchases CPC’s total production at a subsidized cost which is assured by the order given on 30 March 2009 by the Supreme Court. This has enabled LGL to offer gas at a lower price to the consumer compared to Shell.

LGL has a storage capacity of 2,500 MT in Mabima - Sapugaskanda while the distribution of products is carried out through 13 main distributors and 1,665 dealers. Vehicle emission testing operations of LEL are offered through 19 fixed centers, 37 semi fixed centers and 51 mobile testing centers around the country.

The leisure sector of LGL is represented by management of Emerald Bay Hotel and Temple Tree Resort & Spa in Induruwa. The hotels will be managed by LGL for a period of three years and the agreements will terminate in 2011. The group revenue increased 24% YOY in FY09/10 while the gross profit gained 29% during the same period. The gross profit margin improved from 18% to 19% in FY09/10.

During the year 31 March 2010, LGL changed the accounting policy with respect to the non refundable deposits, recognition of cost of sales and sales relating to cylinders.

The group recorded a net profit of Rs.528 Mn in FY09/10. The revenue contribution from trading of LPG was 95% while the profit contribution was a significant 99%. The net profit (NP) margin of the group increased from 5.05% to 9.45% in FY09/10.

The revenue and profit growth can be attributable to the favorable pricing strategy and the growth in demand. Revenue growth has continued during the first four months of FY10/11 and increased 40% compared to the same period last year according to the unaudited figures. Profit for the period reached Rs.262 Mn compared to Rs.187 Mn for the four months ended July 2010. The proceeds of the IPO will be utilized as follows;

* Business Expansion – Rs.505 Mn

Expansion of the existing 2,500 MT storage and filling capacity of LGL - Rs. 425 Mn

Expansion of the distribution network of LGL – Rs.40 Mn. LGL plans to add 6 main distributors and 335 dealers to the existing distribution network.

Introduction of new LP gas products – Rs.40 Mn

nSettlement of financial facilities obtained by LGL – Rs.850 Mn.

nEquity investment in LLL to build and operate a hotel in Chilaw – Rs.500 Mn. LLL plans to commence construction of a four star 100 room hotel in Karupakane in Chillaw. The soft opening of the hotel is planned for 2012.

nEquity investment in LPDL to build and operate service apartments/motel at Havelock Road – Rs.425 Mn. The proposed service apartment complex will consist of 72 apartments which is to be completed in 2012.

nEquity investment in LEL to settle the financial facilities obtained by LEL – Rs. 225 Mn

Risks

Competition with a government owned LPG supplier (as a result of the government buying back operations of Shell). Regulated pricing - LPG prices have a direct impact on inflation and hence would be economically and politically sensitive. Further prices are susceptible to change (eg - petroleum industry) with the possible entry of a government owned entity.

Dependency on CPC - Cost savings on freight charges enables LGL to offer its products at a lower price. LGL faces the possibility of CPC supplying to a government owned LPG supplier going forward.

The management could lose focus on LGL’s core operations (trading of LPG) by diversifying into hotels and property where the company does not possess a proven track record (cost estimate of Rs.500 Mn for a four star 100 room hotel also seems doubtful).

Retiring debt during a low interest rates period - Generally the cost of equity is perceived to be higher than cost of debt. Thus LGL will not be able to enjoy the cost benefit arising from debt.

Financial Forecast

We have assumed a revenue growth rate of 20% for FY10/11 keeping in line with the expected growth of the industry. NP margin is assumed at 13.83% which is comparable to margin recorded in FY09/10 (after adding back the finance cost and tax). A tax at a rate of 20% was considered as the concessionary tax rate is expected to increase in April 2010.

Accordingly, we estimate an EPS of Rs. 2.02 for FY10/11 with a forecasted net profit of Rs.783 Mn.

Valuation

In the absence of an ideal proxy, we have considered Chevron Lubricants PLC (LLUB) as a comparative company for the P/E based valuation. LLUB is predominantly engaged in the business of importing, blending, distributing and marketing of lubricant oils.

Thus both LLUB and LGL use refined products of crude oil as the raw material for their respective operations. At present LLUB trades at a forward P/E of 13X based on earnings for FY10. Hence a forward P/E of 13X is appropriate for LGL. Thus we estimate the intrinsic value at Rs.26.00. The trailing P/E at Rs.26 is 20X.

Sentiment Factors

The above mentioned risks create an uncertainty over the long term profitability. However the investor sentiment appears to be strong. Thus it may result in satisfactory short term gains in the secondary market. BUY