February 1, 2012

Jain Irrigation Systems Limited (NSE: JISLJALEQS)

Outlook and forecasts: Given the dependence on government subsidies, JISL would tend to do well in an environment where economic activity is improving, as rising tax collections would alleviate fiscal pressures and facilitate timely subsidy payouts. However, the current environment does not inspire confidence in such an outlook, mainly because central and state fiscal deficits are unlikely to reduce in the near-term given the slowing economic activity and Central Government's plan to incur substantial new subsidies under the recently announced "Food Security Bill". As such, our base case is that JISL will continue to experience long working capital cycle of around 185 days (but expect a range of 170-200 days) over the medium-term. Further, we expect JISL to increase its revenues at an annual rate of about 22.5% (range of 20-25%), which implies revenues of Rs. 45 billion and Rs. 55 billion in the 12 months to Sep-2012 and Sep-2013, respectively. Operating margins are likely to remain stable at around 19-20% over the same period. Valuation and sensitivities: Based on the above expectations, our "median" fair value estimate of JISL is approximately Rs. 110 per common share, implying an upside potential of some 15% over the current price of Rs. 95. However, our median estimate is particularly sensitive to JISL's working capital cycle, and we would not be surprised to see the share price decline to around Rs. 70, if the working capital cycle were to deteriorate to say 200 days. That said, long positions at that level could mean a high certainty of a profit to those who exercise enough patience and hold-on to their investment. Contrarily, if the working capital cycle were to improve to around 170 days, which is what we'd expect when fiscal pressures are not as intense as they currently are, share price should increase to around Rs. 150-160. Overall, while it will be vital to watch the trajectory of the working capital cycle over the next few quarters, at current market price of Rs. 95 per share, the risk-return profile of an investment in JISL appears attractive from a long-term perspective.

Business model: Jain Irrigation Systems Limited (JISL) is the second largest manufacturer and marketer of micro irrigation and piping systems (MIS) globally and a leading processor of agro products. Significant part of the company's revenues though come from sale of MIS, demand for which is mainly driven by government subsidies to promote adoption of micro irrigation. These subsidies typically range between 70-90% of the cost of MIS but subsidy payouts are usually delayed, taking between 6 and 12 months. As a result, JISL experiences a long working capital cycle -- some 185 days of LTM sales, as of Sep.30, 2011 -- a significant drag on a business that generates after tax return on capital of around 17-18%, but owing to the payout delays, cash return of only 9-10% p.a. Recent developments: The delay in subsidy payouts is a long-standing and widespread issue across sectors, and is one without any structural solutions so far. Therefore, in a bid to alleviate the pressure on its balance sheet, JISL plans to sponsor a 40% owned unconsolidated NBFC, with remaining stakes held by JISL promoters and other investors. According to JISL, the NBFC will finance customers, thereby helping in reducing the company's working capital needs and passing-on the interest cost associated with subsidy delays to the end customers. In our view however, the proposed NBFC would not alter the underlying economics of the subsidy-driven MIS business. JISL would still own at least 40% of the economic risks associated with customer financing -- perhaps more as the offbalance sheet structure may encourage aggressive lending practices (for ex. 15% down payment vs. a minimum of 30% currently). Further, JISL might not save much on interest costs as it may need to compensate the incremental costs to customers via price cuts. As such, we don't see material "economic" benefits (as opposed to "accounting" benefits) from the proposed NBFC. If anything, the "off-balance" sheet customer financing structure would tend to obfuscate investor visibility in the core business and therefore could be a negative from a corporate governance perspective.

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