PRIVATE CLIENT RESEARCH INITIATING COVERAGE SEPTEMBER 18, 2012

Amit Agarwal [email protected] ABG Shipyard +91 22 6621 6222 PRICE : RS.340 RECOMMENDATION : ACCUMULATE TARGET PRICE : RS.370 FY14E P/E: 7.9X

Stock details ABG Shipyard is the largest shipyard in India with ~Rs 158 bn orderbook, of which the company is yet to start work on orders worth ~Rs106 bn. BSE code : 532682 NSE code : ABGSHIP This provides revenue visibility till FY15E. This gives ABG sufficient head- Market cap (Rs mn) : 17150 room to ride out volatile economic factors. It has gradually ramped up its Free float (%) : 38 ship-building capability to construct vessels up to 250 metres in length 52 wk Hi/Lo (Rs) : 405/270 and 120,000 DWT, and also jack-up rigs. The company is well poised to Avg daily volume : 50,000 exploit impending growth in the offshore business led by: i) credible track Shares (o/s) (mn) : 50.9 record, ii) strong clientele, iii) huge capacity, strong execution pace and technical capability and iv) its success in receiving subsidy from the Gov- Summary table (Rs mn) FY12 FY13E FY14E ernment - till date it has received Rs 1500 mn as subsidy. However the shipbuilding industry currently is going through a downturn due to poor Sales 24,238 27,314 31,000 Growth (%) 18.3 12.7 13.5 inflow of fresh orders especially from the commercial segment. Also there EBITDA 6,436 6,986 7,555 is no clarity on the new subsidy policy. Both these factors may keep the EBITDA margin (%) 26.6 25.6 24.4 sentiments subdued for the sector. Based on 9x FY14E PE, we value ABG PBT 2,833 2,980 3,372 Shipyard at ~Rs 370/share. We initiate coverage on ABG with ACCUMU- Net profit 1,848 1,997 2,259 EPS (Rs) 36.3 39.2 44.4 LATE. Growth (%) (3.9) 8.0 13.1 CEPS (Rs) 70.2 68.5 76.9 Key investment arguments BV (Rs/share) 387.1 428.1 475.9 Dividend / share (Rs) 4.7 4.7 4.7  Robust order book gives revenue visibility for 3-4 years. ABG Shipyard is ROE (%) 9.4 9.2 9.5 the largest shipyard in India with ~Rs 158 bn orderbook, of which the ROCE (%) 6.3 7.0 7.5 Net cash (debt) (32,182) (31,022) (27,033) company is yet to start work on orders worth ~Rs106 bn. The unexecuted NW Capital (Days) 218.8 253.6 204.2 order book is 4.5 x FY12 sales, which gives strong revenue visibility for the EV/EBITDA (x) 7.7 6.9 5.5 next three to four years. With a diversified customer base, the order book P/E (x) 9.6 8.9 7.9 P/Cash Earnings 5.0 5.1 4.6 ensures adequate utilisation of ABG's expanded capacity over the medium P/BV (x) 0.9 0.8 0.7 term. Source: Company,  Defence and offshore segment to provide growth impetus. Because of Kotak Securities - Private Client Research its size, experience in execution of defence orders, technological tie-ups and receipt of licence for manufacturing high-end defence vessels, we expect ABG Shareholding pattern to be a strong contender for the Rs 500 bn defence orders lined up by the Public Government of India for the next 10-15 years. We expect ABG to also benefit 11% from an increase in global demand for jack-up rigs and offshore support Corporate Bodies vehicles (OSVs) following an increase in oil and gas exploration activities. OSV 21% and rigs constitute ~ 17% and 26%, respectively, of the company's gross order book. Domestic  Strongly poised to exploit offshore dynamics. In the past two years, new Institutions Promotor 3% 62% orders had dried up in the offshore industry, but given the improvement in FIIs industry dynamics in the past one year and as >40% of the fleet (offshore + 3% related) is still >25 years old, it is only a matter of time before pent-up demand leads to new contracts. Source: ACE Equity  Improving execution capability; rig business to provide further upside. One-year performance (Rel to Sensex) The company is currently operating at 100% utilisation levels and has been ramping up its capacities to make sure that timelines on execution is maintained by the company. It has so far spent around Rs 16 bn in acquiring Vipul shipyard and setting a rig yard in Dahej, which will allow it to build <120,000dwt ships and increase execution capability for smaller ships. The company has also acquired majority stake in Western India Shipyard Ltd.

Source: ACE Equity

Registered Office: Kotak Securities Limited, Bakhtawar, 1st floor, 229 Nariman Point, Mumbai 400021 India. INITIATING COVERAGE September 18, 2012

 Receipt of subsidy would be a boon, but may come very late. ABG till date has booked a total of Rs 6681 million as subsidy for which it has received only Rs 1500 as subsidy payment. Receipt of the balance subsidy amount would help ABG to reduce leverage and would also make valuations attractive for the company. However, we believe that ABG would receive the subsidy very late in the future. (as it is very difficult to put a timeline for the receipt of the subsidy).

We initiate coverage with  Macro headwinds for ship building hurting order inflow. Shipbuilding ACCUMULATE rating on ABG industry is up against weak fundamentals. Very low freight for bulk carriers Shipyard with a price target threatens the business outlook for building bulk carriers. We estimate the of Rs.370 freight rates for dry bulk to remain under pressure in the foreseeable future. A fall in oil price (though unlikely) would also threaten the demand outlook for vessels catering to off shore oil exploration and production activity. We estimate that orders would be tough to come from the commercial shipbuilding segment and would be slow from offshore industry and the Indian Navy.

Valuation  We are valuing ABG at 9 x FY14E P/E in line with our view that the shipbuilding market will remain subdued in CY12 and CY13. We are considering ex subsidy FY14E EPS of Rs 41 while arriving at the target price as we believe that ABG would receive the subsidy very late in the future. (very difficult to put a timeline for the receipt of the subsidy). This leads to a target price of Rs 370/- for the stock. Orders would be tough to come from the commercial shipbuilding segment. Orders from offshore industry and navy would continue to flow though at a slow pace. We are assigning a multiple of 9 x to the one year forward P E to reflect the slowness in the industry. Receipt of accumulated subsidy and flow of fresh orders would act as valuation support and would provide upside for the stock.  The target multiple of 9x FY14E earnings is at a discount to target P/E of Korean and Singapore shipyards (average 12x CY12E, 10x CY13E), which are much larger in scale (catering primarily to vessels such as large crude carrier, containerships, and LNG tankers), have similar earnings growth over the next few years. PE of 9x would be at lower end of the long term one year forward PE band for ABG.

Risk and Concerns  Delay in execution of rigs and large vessel orders  Delay in subsidy payment could stress cash position  Failure in bagging more orders for execution beyond FY14 could impact the company's revenue and profitability  Fall in Crude oil price could impact the E&P capex cycle and result in reduced demand for offshore vessels  Declining premium in prices of second hand vessels over new ones increases risk towards order inflows.  Delay in payment from stressed ship-owners leading to higher working capital requirement

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COMPANY INTRODUCTION ABG Shipyard is the largest private shipbuilding and repairing company in India. The company, which is the flagship company of the ABG Group, was established in 1985. The company was originally incorporated as Magdalla Shipyard Pvt Ltd, before being taken over by the Agarwal Group in 1989. Its shipbuilding facilities in Surat and Dahej, Gujarat, conforms to ISO 9001:2000 quality standards for production. Over the past decade, the company has grown significantly, establishing a niche position in the Indian shipbuilding industry. ABG’s revenue has grown at a CAGR of 37% during FY05-10. The company has so far delivered 143 vessels.

Key Milestones Year Key milestones

CY89 Acquisition by the Agarwal Group CY92 Unique ship lifting facility CY93 First major domestic order - four mini bulk carriers for Vikram Ispat Ltd CY94 Order for three cement carriers for Gujarat Ambuja Cement Ltd First export order CY00 First government order (Indian Coast Guard) for two interceptor boats CY02 Introduction of subsidy scheme for private shipyards CY05 IPO and listing of shares on the BSE CY07 Listing of shares on the NSE; acquisition of Vipul Shipyard CY08 Shipbuilding and rig building commenced at the Dahej shipyard CY10 Acquisition of Western India Shipyard

Source: Company

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KEY INVESTMENT ARGUMENTS

Continue to have a strong order book position ABG has a strong orderbook consisting of bulk carriers, jack-up rigs, cement carriers, cadet training ships, anchor handling tugs or supply vessels and offshore support vessels. The order book is valued at ~Rs 158 bn as on June 30, 2012, of which work on order worth ~Rs 106 bn is yet to be started. Net order book is 4.5 x FY12 revenues, which provides revenue visibility for the next three to four years. Company has a strong order Despite a slowdown in the global shipbuilding industry, ABG has bagged orders book of Rs.106bn yet to be worth ~Rs 40 bn after FY10, including big-ticket orders for two jack-up rigs worth executed ~Rs 20 bn and two training vessels for coast guard worth ~Rs 10 bn. The order book is diversified among financially-sound oil support companies, fleet owners, product owners and coast guard who are not traders but end-users of the ships. This has worked well in the current downturn, resulting in no order cancellation from its customers. Also, the company has established business relationships with its customers and there are a good proportion of repetitive orders in its bouquet, which shows the strength of its shipbuilding skills. The company is currently working at 100% capacity utilisation and has been ramping up its capacities to make sure that timelines on execution is maintained. The last delivery from the current order book is scheduled in 2015.

Segment wise order book Segment Percentage of order book Key clients

Bulk carrier 41.5 PFS, Vogeman, Precious AHTS 9.3 PFS, Varada, SCI Training vessels 5.0 Indian Coast guard Other offshore vessels 20.5 Toisa, Varada Jack up rigs 23.7 M/S Drilling and Offshore

Source: Company

Analysis of order book Quote from a new building broker from HongKong – “the dry bulk market is severely overtonnaged and it will be years before we see another round of mass ordering like we did over the past few years. Until then, owners will be very picky about where they order their ships” The company hasn't received any significant orders in the last 24 months in the bulk segment - infact this could give it the much needed breathing space to catch up on production delays, often stretching between three and six months depending on the vessel type. Company has been working at 100% capacity and deferment of delivery dates would benefit ABG in the same way, as its order book is burgeoning with orders pegged at 4.5 x times its FY12 sales with last delivery schedule in 2015. It is important to note that due to current economic slowdown and sluggish ship freight market, even ship-owners are asking for deferment of deliveries. Management of ABG indicated that the current situation has led to an implied understanding between the company and its clients, wherein both the parties are comfortable with some delay in deliveries.

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Client analysis Key Clients Percentage of order book Type of vessel

Essar Shipping 21 Jack up rig worth US$480mn and bulk carriers Precious 17 Bulk Carriers Most of the clients are recurring Vogeman 11 Bulk Carriers with strong credibitliy Pacific First 6 Bulk Carriers and OSVs Defence and coast guard 8 Pollution control vessel, intercepter boats, Patrolling vessel M/S Drilling and Offshore 12 Jack up rig worth US$480mn Others 25 Miscelleanous Total 100

Source: Company

It’s also notable that the company hasn’t received any major request for order cancellation or deferral in the last one year of economic crisis. If we exclude the vulnerable orderbook of 20%, the balance unexecuted order book of Rs 80 bn (80%) still gives us earnings visibility for the next 3 years, good enough to sail through the tough times and by then the company would have received fresh orders. We expect orders for the offshore segment (especially from Essar group) to continue to flow, though the pace may be be a tad slow and for the bulk segment we expect the orders to start flowing from FY14. We have assumed the gross order book to grow at 10% per annum from FY12 to FY14E.

Defence segment is a big opportunity The Indian Navy has three dedicated Shipyards - Mazgaon, Garden Reach and Goa. The requirement of Navy & Coast Guard Production is split amongst the 3 leaving only the spill over, if any, to non defence shipyards. But they have not been able to produce all the ships that the Navy needs. Even today the Navy imports ships to meet its growing demand. The primary reason for this is the long build times for ships, which is due to antiquated equipment and/or building methods in our shipyards. Shipyard productivity has to improve to a level where they can meet all the requirements of the Navy. Today ABG has received all the technical clearance to bid for naval orders. Recently, the company received a licence for design and construction of naval warships, submarines, fast attack crafts and other kinds of defence ships. It has also entered into MOUs with leading global marine engineering and shipbuilders for joint bidding for defence vessel contracts in India, technological assistance and consultancy.

MOU’s signed by ABG for technological support Company Country Profile

Hyundai Heavy Korea World’s number one shipbuilder with around 15% market share in the global Industries shipbuilding industry. Capable of building all types of ships. It has delivered more than 1,593 ships to 258 ship-owners in 48 countries since 1972.

Rosoboronexport Russia Government corporation, which is exclusively entitled to supply the whole range of Russian armaments. It has also delivered stealth frigates (war ships) to the Indian Navy

Northrop Grumman US One of the largest defence companies globally with expertise in defence, aerospace, navigation, naval and marine systems.

Man Ferrostaal Germany International manufacturer of vehicles, engines and machinery.

Source: Company

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 Larger orders won’t come to ABG for the time being Our talks with a couple of defence yards suggested that the private shipyards would continue to get only orders for surveillance boats, interceptor boats, pollution control vessels and some smaller boats from the navy and the coast guard. For the next few years the larger orders would continue to go to PSU yards and foreign yards till ABG develops a good track record of quality and timely delivery.

 Share of Navy in Defence Budget Historically the allocation to Navy from the defence budget has hovered around the 17% mark and this we believe would gradually be increased to 20% as India will certainly need a powerful Navy as it takes up greater responsibility in world affairs and also protects its 7000 km long coast line.

Indian Defence Budget allocation (Rs crs) FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13

Total (Rs Crores) 83,000 89,000 96,000 105,600 141,700 147,344 164,000 193,000 YoY growth (%) 7.23 7.87 10.00 34.19 3.98 11.30 17.68 Allocation Navy (17%) 14,110 15,130 16,320 17,952 24,089 25,048 27,880 32,810 Orders for smaller ships (25% of navy) 3,528 3,783 4,080 4,488 6,022 6,262 6,970 8,203

Source: Industry

We estimate the defence opportunity to be worth Rs 82 bn in FY13E for all the private yards (more than 20 operational) including ABG, Pipavav and Bharati. We estimate defence segment to contribute about 10% of the revenues for ABG till FY14E and only from FY15E onwards the share to move up.

Offshore support vehicles segment a key driver We expect an increase in global demand for jack-up rigs and OSVs on the back of an increase in oil and gas exploration activities due to high oil prices and rise in Company intends to focus on global demand for oil. Indian shipbuilders have proved their capabilities in this offshore segment segment and have a market share of around 6% in the deliveries made in the past few years. ABG’s vast experience in manufacturing OSVs, especially anchor handling tug\ support vessels (AHTSVs), is likely to give it an edge over others. OSVs and rigs constitute around 17% and 26% respectively, of ABG’s gross order book. We also expect some amount of replacement demand from scrappage over the next two years because a) more than 50% of the global AHTSV fleet is over 25 years of age and are likely to be replaced, and b) old vessels are standardised and small, and there is increase in preference for large multipurpose efficient vessels.

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 Ramping up capacity The company has been ramping up its capacities to make sure that timelines on execution is maintained. The last delivery from the current order book is scheduled in 2015.

Surat & Vipul shipyard Company has been enhancing The company has modernized the Surat yard spending around Rs 1.5 bn enabling capacity to maintain timelines faster and quality execution of order book. in delivery ABG has acquired Vipul Shipyard (through a Memorandum of Understanding), which is adjacent to its Surat facility. It has also acquired the land of about 8 acres adjacent to Vipul shipyard spending a total of Rs 600 mn. Presently the yard is constructing 8 vessels for the Navy (old orders under the hitherto promoters) which would take another 15 months from today and only after that ABG would start taking orders for execution from this yard. On paper the yard belongs to ABG but revenues from the existing orders will not be consolidated in books of ABG. The yard would start contributing to the topline only from FY14 when it actually starts accepting orders for itself for the facility. We believe this new facility will increase the company's Surat execution capacity by 25% from FY14. Expansion of Surat yard would be in synergy with Vipul shipyard.

Dahej Dahej facility is being built in 2 phases. The first phase of the Dahej shipyard has already been constructed at a cost of Rs 4 bn - it can build ships of up to 120,000 DWT, targeting the dry-bulk segment. The 2nd phase at Dahej involves construction of a rig building facility- a lucrative segment, and would be fully operational by end of CY12. ABG has already spent around Rs 10 bn for the same. The rig yard is capable of constructing 4 rigs simultaneously. The company has already bagged an order from Essar Shipping Ports and Logistics in October 2008 for construction of two 350 feet Jack-up Rigs worth Rs 20 bn (US$ 440 mn) to be delivered by 2014 and an another order for two 350 feet jack up rig from group company M/S Drilling and Offshore.

Western India shipyard Limited (WISL) ABG acquired WISL in October 2010 by raising its stake from 19.7% to 60.3% in off-market deals from ICICI Bank, for ~Rs 355 mn. The company was a loss-making entity since its inception in 1996, but it turned around in FY10 and recorded net profits for the first time. The company recorded revenues of Rs 896 mn and PAT of Rs 122 mn in FY12, which is ~4% and ~7% of ABG's consolidated revenues and bottom line, respectively. Ship repair is considered to be a high ebidta margin (30%) business if managed well with labour as the key input. WISL with its strategic location of Goa makes it a more attractive business proposition. We estimate ABG to capitalize on the ship repair opportunity in the country following its acquisition of Western Indian Shipyard Ltd (WISL) and gain from the latter’s experience and expertise. WISL is the largest domestic ship and rig repair company in the private sector and has around 20% market share in the Indian ship repairing business. It has a modern state-of-the-art floating dry dock that enables it to repair various types of vessels up to 60,000 DWT. Currently it has ship repair orders worth Rs 200 million (short term orders).

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 Small capex of Rs 5 bn over FY12 to FY14E - debt to recede going forward We estimate the company to spend another Rs 5 bn over FY12 and FY14E in further modernizing the facility and towards purchase of modern equipment's which would help ABG in faster and quality execution. With free cash flow generation of Rs 8.4 bn over FY12 and FY14E, we estimate the debt of the company to recede going forward. However, huge working capital requirement may not bring the gross debt level significantly down.

Summary of capacities/infra of ABG Facility/Infra Details Others

Total shipyard area 35 acres Dry Dock 1 125mt * 22.5 mt*7.5 mt Dry Dock 2 155 mt *30 mt *7.5 mt Shiplift 200 mts and 150,000 dwt To be operational from Q1FY14 Berth 1 120 mt * 6 mt Berth 2 60 mt * 30 mt Fabrication Shop Four covered Bays Blasting Shop Two blasting Shops Others Goliath cranes

Source: Company

The Indian Advantage for Shipyards

 Availability of low cost and technically qualified manpower For Indian shipyards labour cost constitutes around 5 to 6 % of the sales while for European or Korean yard it is as high as 12 to 13%. Also Indian labour is far more skilled than labour from any other country.

Comparison of labour cost  Vast coastline Country Cost per year in $ Fortunes of the shipbuilding industry are closely tied to that of the shipping industry.

China 948 With its vast coastline of over 7000 kms, 11 major ports and several intermediate Indonesia 1,310 and minor ports, shipping occupies an important position in the country's trade and India 1,550 commerce. Today 95% of India's export trade by volume and 75% by value are Philippines 3,185 carried through the sea route. With the economy growing the vast coastline acts as Thailand 3,517 a demand driver for Indian shipbuilding companies Malaysia 4,458 Korea 13,966  Few initiatives from Government of India (GoI) Singapore 27,712

Source: Industry Keeping in mind the ability of the Indian shipbuilding industry to generate employment and foreign exchange earnings, the GoI has announced a National Maritime Development Policy to strengthen the industry. The GoI has also announced 100% FDI in shipbuilding and earlier had a subsidy scheme for the industry which may be extended.

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Subsidy scheme for Indian Shipyards

 Expiry of old subsidy scheme in August 2007 Subsidy is critical for the Indian The old subsidy policy was introduced for a five-year period ending August 2007. Shipyard industry The policy included cash subsidy of 30% of the sale price on most of the foreign orders. Ships on domestic orders were however be eligible for subsidy if: 1) The vessels were a minimum of 80 meters in length; and 2) The orders are won through a global tendering process

 Approval of subsidy element While technically the sales price of the ship value is to be used for the subsidy calculation; the sales price is evaluated by Directorate General of Shipping (DGS). The DGS evaluates the sale price and may alter the ship value before awarding in principle approval. Historically in-principle approval has been marginally below the sales price. For private players the subsidy payment is made only after the delivery of the ship; while the payment to the public sector yards is stage based. Following the in-principle approval a budget is sanctioned after which final payout is made. The release of subsidy is strictly subject to availability of budget provision and the shipyard satisfying the conditions laid down in the subsidy scheme and any other guidelines issued by the Government from time to time.

 Rationale for subsidy Subsidy on an average forms 5 to 10 % of sales and 10 to 30% of net profit. It is important to note that rigs, defence ships and certain category of commercial vessels are not eligible for subsidy. This subsidy is not considered as a grant by the shipbuilding industry. It's regarded as refund of taxes to shipbuilders. Subsidy is motivating as shipbuilding is a capital intensive industry and Indian yards are competing with global yards in Korea, Japan and China where their industry receives direct and indirect support from the government. As per the Ministry of Shipping, incentive schemes, lower statutory levies, fewer financial charges, ancillary support, bulk discounts, etc. in countries like Korea and China have put Indian shipyards at a 35-55% cost disadvantage. So in the absence of a subsidy, margins for Indian shipyards would fall and Indian players will find it difficult to compete and scale-up.

 However subsidy eludes shipyard companies including ABG Since 2005 till date ABG has booked subsidy totalling Rs 6681 million for which it has received payment of ~Rs 1500 million from the government. Over the years the reluctance of the government to make any significant budgetary provision for the same has seen shipyards across the country accumulating subsidy in their balance sheet artificially inflating their working capital.

Analysis of subsidy booked by ABG (Rs mn) FY08 FY09 FY10 FY11 FY12

Revenues 8,851 13,501 16,282 20,487 24,238 Subsidy 817 628 1,823 851 487 Subsidy as % of revenues 9.2 4.7 11.2 4.2 2.0 PAT 1,608 1,700 2,171 1,908 1,800 Subsidy post tax 547 421 1,221 570 326 Post tax subsidy as % of PAT 34.0 24.8 56.3 29.9 18.1

Source: Company

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Subsidy continues to be big concern even for ABG as it is still forming almost 18% of the PAT currently. For ABG subsidy (post tax) as percentage of PAT over the years may have come down from 34 % in FY08 to ~30% in FY11 and to 18% in 2012, but 18 % is still considered very high. It suggests that 1/6 of the return metrics to be attributable to subsidy. However going forward subsidy factor should come down further for ABG as the company would be constructing four 350 feet Jack up rig (worth Rs 40 bn or 40%of the order book) and orders for navy which are not eligible for subsidy.

 Margins may not drop without subsidy scheme The subsidy scheme had helped ABG’s EBITDA margins to more than 25% during the past three to four years compared to 17-18% for global peers. Post the execution of the subsidy-eligible current orders (after FY14), EBITDA margin of the company may come under pressure. However we believe, the margins would be compensated by high margin offshore (30% Ebidta margin) and navy (30% Ebidta margin) in future.

Concerns

 Execution of rigs – new domain ABG has started building jack-up rigs, which is a relatively new domain for the company. It is currently executing four rig orders of around Rs 10 bn each. Execution challenges here can significantly affect inventory and other related losses. However, to mitigate the risks related to the lack of rig-building experience, the company has tied up with Friede & Goldman (US) for the design and with Megaway (Singapore) for detailed engineering. Hence, execution of rig building orders is a key monitorable. Successful execution will help the company bag more orders from E&P players.

 New order flows The shipbuilding industry is linked to the shipping companies’ fortunes, which in turn depends on global economic growth. With the recent downturn in economic growth and a subsequent fall in freight prices across all categories, the shipping industry is going through a sluggish growth phase. While ABG has secured orders, which will keep it occupied till FY15, any delay in bagging more orders for execution beyond FY14 could impact the company’s revenue and profitability.

 Competition from foreign yards in commercial segment Foreign yards - particularly those in Japan and Korea quote much lower rates and operate at much lower margins. Also these shipyards have much better technology capable of handling more complex work. Internationally, there are 5 levels of automation. Level 1 represents the basic level of automation whereas level5 represents highest level of automation. None of the Indian shipyards is at level 4 and 5. As a result the order book of Korean and Japanese shipyards is ballooning. Most of the Indian orders are also going to Korean and Japanese shipyards. Today the consolidated order book of Indian shipyards just constitutes 0.75% of the global order book.

 Falling ship prices to hurt demand for building new ships Prices of ships of 5 years of age have fallen over 50% in the last two years to 50% below the contracted price. Falling asset prices are forcing ship owners to (1) cancel contracts for building new ships at or above market price (2) reduce contracted price or (3) delay taking delivery of vessels due to the cash crunch. Lead indicator of this is, ABG commencing work on certain contracts without upfront compensation (even delayed compensation) leading to higher working capital working requirement.

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FINANCIAL ANALYSIS

 Revenue CAGR of 13% over FY12 to FY14E amidst uncertainty Despite the economic slump we expect ABG to post revenue CAGR of 13 % over FY12 to FY14E. This we expect primarily because of the healthy unexecuted orderbook of Rs 106 bn the company has as on today to be executed by 2015. It provides us with strong earnings visibility for the next 3 to 4 years. It will also enable the company to sail through the global slowdown.

 Operating margins to decline over FY12 ABG’s operating margins is estimated to decline marginally in FY13 and FY14 due to increase in fixed operating expenses after the capacity expansion at the Dahej shipyard. However, it would still be higher than the global industry average because it caters to requirements like customized vessels with special features and enjoys superior margins over global leaders who generally manufacture standardised vessels. The company also enters into back-to-back agreement for sourcing of major raw materials, machine, equipment, etc., hence securing its margins. WISL’s repair business enjoys higher margin of around 30%; going forward, the repair business is expected to contribute 6-7% to the top line. Post the execution of the subsidy-eligible current orders (after FY14), EBITDA margin of the company may come under pressure. However we believe, the margins would be compensated by high margin offshore (30% Ebidta margin) and navy (30% Ebidta margin) in future.

Operating margins to fall in near term

30.0 26.6 25.6 24.4 25.0 21.0 20.0 17.7 15.0 10.0 5.0 ‐ FY10 FY11 FY12 FY13E FY14E

Source: Company, Kotak Securities - Private Client Research

 Raw material policy to keep working capital requirement high The company currently has a huge Inventory of Rs 38 bn for the current unexecuted orderbook position of Rs 106 bn. The inventory is primarily on account of the purchase of raw material for the rigs (the company purchased almost the entire raw material before the contract was signed and is yet to receive advance payment for the same) and the company sponsored the same through working capital debt increasing the debt in the balance sheet and also the interest payment. The company has this policy of purchasing raw material to the extent of 10% to 30% of the total requirement of a ship as an when it receives/wins an order and hence the company would always have huge working capital requirement.

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 Debt equity and free cash flow analysis Under uncertain business environment we are not comfortable with the consistent increase in leverage as measured by Gross Debt to EBITDA of above 4 x. We estimate the gearing to remain high as receivable days is going to expand as customers may not manage to fund timely delivery leading to lower cash flow. The key comfort factor for us is the company’s healthy order book. ABG has always maintained a moderate financial policy with a conservative dividend policy pursuing its growth strategy. The operating cash flows won’t be enough to meet the growing working capital needs and hence the company is resorting to borrowing to meet the same and also to meet the capex requirement.

Debt and cash flow analysis (Rs mn) FY10 FY11 FY12 FY13E FY14E

Gross Debt 28,974 25,423 35,740 33,916 32,274 Networth 14,270 16,940 19,703 21,791 24,183 Cash 316 6,534 3,558 2,894 5,240 Net Debt/equity (x) 2.0 1.1 1.6 1.4 1.1 Gross Debt /EBITDA (x) 10.1 5.9 5.6 4.9 4.3 Operating cash flow (499) 10,668 (5,391) 3,758 6,875 Free cash flow (5,565) 5,865 (13,086) 1,108 4,225 Capex 5,066 4,803 7,695 2,650 2,650

Source: Company, Kotak Securities - Private Client Research

Peer Analysis Company Country ROE (%) P/E (x) EV/EBIDTA (x) P/B (x) FY12 FY13E FY12 FY13E FY12 FY13E FY12 FY13E

Pipavav Shipyard India 9.6 15.2 18.8 9.4 9.4 5.9 2.3 2.1 Hyundai heavy South Korea 9.9 9.3 9.2 8.1 7.4 7.1 0.9 0.8 Daweoo Shipbuilding South Kore 9.3 10.1 10.5 8.8 8.5 7.9 1.0 0.9 Sembcorp Singapore 26.6 25.3 16.3 14.1 12.4 11.2 3.9 3.5 Keppel Singapore 22.0 18.0 12.3 10.8 11.5 10.4 2.3 2.1

Source: Kotak Securities - Private Client Research

1 year forward PE band

Price (Rs) 4x 8x 12x 16x 600

450

300

150

0

Source: Bloomberg, Kotak Securities - Private Client Research

Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 12 INITIATING COVERAGE September 18, 2012

VALUATION & RECOMMENDATION We are valuing ABG at 9 x FY14E P/E in line with our view that the shipbuilding market will remain subdued in CY12 and CY13. We are considering ex subsidy FY14E EPS of Rs 41 while arriving at the target price as we believe that ABG would receive the subsidy very late in the future. (very difficult to put a timeline for the receipt of the subsidy). This leads to a target price of Rs 370/- for the stock. Orders would be tough to come from the commercial shipbuilding segment. Orders from offshore industry and navy would continue to flow though at a slow pace. We are assigning a multiple of 9 x to the one year forward P E to reflect the slowness in the industry. Receipt of accumulated subsidy and flow of fresh orders would act as valuation support and would provide upside for the stock. The target multiple of 9x FY14E earnings is at a discount to target P/E of Korean and Singapore shipyards (average 12x CY12E, 10x CY13E), which are much larger in scale (catering primarily to vessels such as large crude carrier, containerships, and LNG tankers), have similar earnings growth over the next few years. PE of 9x would be at lower end of the long term one year forward PE band for ABG. For arriving at the target price we have also factored in 1) no new order wins in short term 2) some cancellation of orders especially in the bulk segment 3) ignores the subsidy factor completely which the company would be receiving sometime down the line.

Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 13 INITIATING COVERAGE September 18, 2012

FINANCIALS

Profit and Loss Statement (Rs mn) Balance sheet (Rs mn) (Year-end March) FY11 FY12 FY13E FY14E (Year-end March) FY11 FY12 FY13E FY14E

Net sales 20,487 24,238 27,314 31,000 Equity 509 509 509 509 Raw material 11,590 12,482 14,476 16,644 Reserves 12,398 14,327 16,087 18,109 Employee cost 729 991 965 1,155 Deferred tax liability 4,033 4,867 5,195 5,566 Other expenditure 3,869 4,329 4,887 5,646 Networth 16,940 19,703 21,791 24,183 - Operating expenses 16,188 17,802 20,328 23,445 Debt 25,423 35,740 33,916 32,274 Operating profit 4,299 6,436 6,986 7,555 Minority interests - - - - + Other income 695 924 550 450 Capital employed 42,363 55,443 55,707 56,457 - Depreciation 699 1,097 1,164 1,244 - Interest 1,458 3,430 3,392 3,389 Fixed Assets (net) 23,884 30,482 31,968 33,374 - Tax 914 985 983 1,129 Investments 2,001 2,289 2,000 2,000 PAT 1,923 1,848 1,997 2,293 Working capital 9,944 19,114 18,844 15,843 + (Associates-Minorities) - - - - Cash 6,534 3,558 2,894 5,240 Consolidated PAT 1,923 1,848 1,997 2,259 Capital deployed 42,363 55,443 55,707 56,457

Source: Company, Kotak Securities - Private Client Research Source: Company, Kotak Securities - Private Client Research

Cash Flow Statement (Rs mn) Ratio Analysis (Year-end March) FY11 FY12 FY13E FY14E (Year-end March) FY11 FY12 FY13E FY14E

Consolidated PAT 1,923 1,848 1,997 2,259 Topline growth (%) 25.8 18.3 12.7 13.5 Non-cash items 1,574 1,931 1,492 1,615 Bottomline growth (%) (4.8) (3.9) 8.0 13.1 Cash profit 3,497 3,779 3,488 3,874 Operating margins (%) 21.0 26.6 25.6 24.4 Inc. in working capital (7,171) 9,170 (270) (3,001) FDEPS (Rs/share) 37.8 36.3 39.2 44.4 Cash flow from opns 10,668 (5,391) 3,758 6,875 CEPS (Rs/share) 68.7 70.2 68.5 76.9 Capital expenditure (4,803) (7,695) (2,650) (2,650) DPS (Rs/share) 4.7 4.7 4.7 4.7 Investments 4,032 (288) 289 - BV (Rs/share) 332.7 387.1 428.1 475.9 Cash flow from invest (771) (7,983) (2,361) (2,650) PER (x) 9.3 9.6 8.9 7.9 Dividends (237) (237) (237) (237) P/C (x) 5.1 5.0 5.1 4.6 Equity raised 109 318 - - Dividend yield (%) 1.3 1.3 1.3 1.3 Debt raised (3,551) 10,317 (1,824) (1,642) P/B (x) 1.1 0.9 0.8 0.7 Inc. in minority interests - - - - EV/Sales (x) 1.8 2.0 1.8 1.3 Miscellaneous items - - - - EV/ EBITDA (x) 8.4 7.7 6.9 5.5 Cash flow from finance (3,679) 10,398 (2,061) (1,879) Debt/Equity (x) 1.5 1.8 1.6 1.1 Net cash flow 6,218 (2,976) (664) 2,345 Working capital turn (days) 241.0 218.8 253.6 204.2 + Opening cash 316 6,534 3,558 2,894 Dividend payout (%) 12.3 12.8 11.9 10.5 Closing cash balance 6,534 3,558 2,894 5,240 ROE (%) 11.4 9.4 9.2 9.5

Source: Company, Kotak Securities - Private Client Research ROCE (%) 5.8 6.3 7.0 7.5 Source: Company, Kotak Securities - Private Client Research

Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 14 INITIATING COVERAGE September 18, 2012

Fundamental Research Team Dipen Shah Saurabh Agrawal Ruchir Khare Amit Agarwal IT, Media Metals, Mining Capital Goods, Engineering Logistics, Transportation [email protected] [email protected] [email protected] [email protected] +91 22 6621 6301 +91 22 6621 6309 +91 22 6621 6448 +91 22 6621 6222

Sanjeev Zarbade Saday Sinha Ritwik Rai Jayesh Kumar Capital Goods, Engineering Banking, NBFC, Economy FMCG, Media Economy [email protected] [email protected] [email protected] [email protected] +91 22 6621 6305 +91 22 6621 6312 +91 22 6621 6310 +91 22 6652 9172

Teena Virmani Arun Agarwal Sumit Pokharna K. Kathirvelu Construction, Cement, Mid Cap Auto & Auto Ancillary Oil and Gas Production [email protected] [email protected] [email protected] [email protected] +91 22 6621 6302 +91 22 6621 6143 +91 22 6621 6313 +91 22 6621 6311

Technical Research Team Shrikant Chouhan Amol Athawale Premshankar Ladha [email protected] [email protected] [email protected] +91 22 6621 6360 +91 20 6620 3350 +91 22 6621 6261

Derivatives Research Team Sahaj Agrawal Rahul Sharma Malay Gandhi Prashanth Lalu [email protected] [email protected] [email protected] [email protected] +91 22 6621 6343 +91 22 6621 6198 +91 22 6621 6350 +91 22 6621 6110

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