A bet on renewable energy

Praj Industry is the worlds largest supplier of technology and equipment for setting up ethanol plants. While 85 per cent of Prajs revenue comes from the ethanol segment,15 per cent comes from supplying equipment and setting up plants for the brewery industry.

Strengths

Research and development Ramp;D is Prajs key strength for which it has set up a dedicated centre,Matrix,at Pune. It is perhaps the only company in the world that possesses the technology to produce ethanol from a wide variety of feedstocks. Hence it can cater to markets globally,since different markets use different feedstocks.

Yet another strong point is Prajs global reach. It has formed a joint venture in Europe and Brazil and set up a subsidiary in the US. It has customers in about 30 countries including Africa,South East Asia Philippines,Thailand and Japan.

Praj has 6 per cent market share globally and 60 per cent share of the domestic market.

It had a cash balance of Rs 331 crore at the end of Q3FY09,which is a positive for these times.

Opportunities

Growing market for ethanol. Between 2000 and 2007,ethanol production doubled globally and touched 49.52 billion litres. It is further expected to grow to 120 billion litres by 2020 at a compounded annual growth rate of 6.5 per cent. Some of the biggest producers of ethanol are US,Brazil,and China account for 78 per cent of production. In India production of ethanol is pegged at 2.2 billion litres,but only about 200 million litres is fuel grade.

About 60 per cent of Prajs order book comes from abroad. Given the robust growth projections for the global market,Prajs technology lead,and its global presence,it should be able to grow its earnings at an attractive rate.

Substituting oil. With oil at around 50-55 per barrel,most of us would think that the demand for alternative fuels such as ethanol would have lost steam. This is only partially true. Besides economics,a variety of other factors drive the demand for ethanol,such as environmental concerns ethanol is a cleaner fuel and energy security non-oil producing countries dont want their foreign policy to be held hostage to their oil import needs.

Moreover,todays depressed oil prices are the result of the global economic slowdown. Says Ashish Kapur,chief executive officer of New Delhi-based Invest Shoppe: Once global economic growth returns to its trend level,oil price is expected to rise to a higher level. He believes that in the medium term 70-90 per barrel is the equilibrium level at which oil will trade,and that the current depressed prices will not sustain. Non-oil producing nations are averse to the idea of high oil prices once again putting pressure on their current account balance.

Moreover,last year ethanols price had shot up due to the rise in the price of food grains. But these prices have fallen since. In Europe,for instance,the price of wheat and corn has fallen from 220 euros per tonne last year to around 70-90 euros per tonnes now. So the production cost of ethanol has also come down,making it viable vis-à-vis oil. In the US,however,the crush margin the price of corn vis-à-vis the price of ethanol is not yet attractive enough. In India,at just Rs 20 plus per litre,ethanol is much cheaper than oil.

Finally,most analysts today are of the view that the world is past peak oil. So as time goes by,the demand for ethanol will only increase.

Government mandates. At present the demand for ethanol is driven primarily by government diktat,i.e.,the government making it mandatory for oil marketing companies to mix a certain proportion of ethanol to petrol. Such mandates force private players to comply and hence augment demand and capacity. For instance,the European market is beginning to look up after the EU Parliament adopted the Renewable Energy Directive last December which mandates that 10 per cent transport fuel should come from biofuels by 2020. This is expected to lead to 12-14 billion litres of capacity addition. Recently the US too revised its national biofuel target of 11 billion gallons about 40 billion litres from 2012 to 2009. Moreover,it targets that 20 per cent of its transportation fuel should come from biofuels by 2017.

At the same time,delays in adopting such legislative proposals can hinder market development. In India,for instance,the government has mandated 5 per cent ethanol mixing in nine states,but even this target has not been met due to supply shortages. The Cabinet has approved the proposal for 10 per cent blending which would augment demand from 560 million litres at 5 per cent blending to 1,100 million litres at 10 per cent,but this is yet to be passed by Parliament.

Recent developments. The decline in interest rates in most economies which reduces the breakeven level of projects,in price of commodities like steel which reduces Prajs project cost,and in food grain prices which reduces the input cost for ethanol and enhances its viability vis-à-vis oil all augur well for Praj.

Challenges

Input price. Currently,the price of ethanol is determined by the price of its feedstock. Over the last couple of years,food prices had shot up dramatically all over the world,and this had raised the price of ethanol as well. More importantly,it led to worries about food security. Diversion of food grain to production of ethanol,it was feared,would stoke food price inflation and worsen food grain shortages,causing socio-political upheavals,especially in poorer nations.

Over the medium to long run,the growth of the ethanol industry and of a player like Praj will depend on how successfully it is able to develop the technology for producing ethanol from non-food grain feedstock like cellulose. Praj has already achieved breakthrough in producing ethanol from sweet sorghum which is non-edible. The plant that Praj was building for Tata Chemicals to produce ethanol from sweet sorghum was slated to start by February 2009.

The company is also engaged in developing the technology for producing ethanol from cellulose. At the conference call held after the Q3FY09 results,Prajs chief executive officer and managing director Shashank Inamdar had claimed that this activity is progressing well. The plant for demonstrating this technology is expected to be up by 2010. Only then will we know how good is this technology and how much demand it garners. It could find takers in markets like the US where there is lot of concern about food grains being diverted to biofuel production, says Jaiprakash Toshniwal,an analyst at ULJK Securities.

Stagnating order book. The ongoing global slowdown and the resultant credit crunch are having an impact on the flow of orders.

Customers,especially those who planned to set up projects by taking loans,are taking longer to decide and are also subjecting their projects to greater scrutiny. Prajs order book has shrunk from around Rs 950 crore in Q2FY09 to around Rs 850 crore in Q3FY09. This is a cause for concern presently.

Limits to blending. Ethanol can be mixed up to 10 per cent without requiring any changes to the car engine and up to 20 per cent with slight modifications. Thereafter,new types of engines will have to be introduced. This will take time.

Currency fluctuations. Being a net exporter,currency fluctuations will affect bottomline.

Management

Praj Industries has a well-qualified and competent management. Its founder chairman,Pramod Chaudhari,is an IIT Mumbai alumnus,while its chief executive officer and managing director,Shashank Inamdar,has studied plant design and bio-technological processes in Europe. So the top management consists of technocrats who understand the business well.

Valuations

Taking into account the huge demand and capital investment that is slated to go into ethanol production across the globe,analysts expect that the company will be able to grow its profitability at a CAGR of at least 25-30 per cent over the next five years.

According to analysts,Prajs estimated earnings for FY10E and FY11E would be Rs 8.2 and Rs 9.1 respectively. At the current market price of around Rs 56,this translates into a PE of 6.9x and 6.2x respectively. As the next one year is expected to remain sluggish,actual growth in earnings is expected to start in FY11. PEG ratio for FY11 is likely to be 0.57,which is attractive.

In the short term,the depressed price of oil and slowdown in order intake due to credit constraints are likely to impact Prajs earnings. But as Manish Goyal,analyst at Envision Capital says: Praj remains a strong play on the renewable energy theme. Investors with the patience to ride out the current slowdown and who have faith in the future of biofuels should take advantage of the current depressed valuations to invest in this stock.

Five reasons why you could invest

amp;149; The company is perhaps the only one in the world that has the technology for producing ethanol from a wide variety of feedstocks: grains,corn,sugarcane,etc.

amp;149; It is working on a technology to produce ethanol from cellulose. If successful,it will end one of the main objections to ethanol today that it diverts grains to producing biofuels,thereby causing food shortages.

amp;149; Governments all over the world are mandating blending of petrol with ethanol. Their mandates are enhancing the demand for ethanol. Governments of non oil producing nations want to produce ethanol for a variety of reasons: to enhance their energy security,for environmental reasons,and so on.

amp;149; Praj has a presence in all the major markets of the world.

amp;149; The price of oil may be in the range of 50-55 per barrel now. But most analysts believe that as soon as the world economy returns to its trend level of growth,the price of oil is likely to rise to 70-90 per barrel.

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