Making more out of the same: Lakshmi Energy and Foods Limited (LEAF), we believe boasts of what could be termed as one of the best business models where every by product is now being or will be exploited commercially. Although the company started off as a pure play non-basmati rice manufacturer, it is now uniquely positioned in two of the fastest growing sectors in the country, food and power. The flow chart below will help you make clear what are we talking about.

As seen from the chart above, over the last few years, the company has branched out into the processing of various value added products, which are likely to add significantly to the company’s topline going forward. While the company’s bread and butter business model was selling rice, nakku (broken rice), rice bran and husk, courtesy still further integration, the company will now be able to sell power (using husk as the feed stock and the first of its kind 30 MW biomass power plant in North India), starch (using nakku), oil processing and refining using rice bran and cattle feed using rice bran de-oiled cake. Furthermore, even the ash produced from the power plant will be exploited commercially by making bricks out of it.

Thus, the downstream integration of this magnitude will not only aid in rapid expansion of its topline, which we expect to grow at a CAGR of 28% between FY07 and FY10, but will also boost the company’s margins. To put things in perspective, operating margins have shot up to 22% during 1HFY08, significantly higher than the 8% witnessed in FY05. While rising food grain prices have helped, margins have also received a boost because of commercial exploitation of otherwise waste byproducts.

Significant expansion plans: LEAF has planned expansion of its facilities over the next 3 to 4 years entailing an investment of US$ 200 m. With the planned addition of paddy processing capacity of 1 m MTPA in 2008, the company expects the capacity to touch 2 m MTPA by FY09 and 3 m MTPA over the next 4 to 5 years. The company currently has biomass power capacity of 30 MW. This is likely to expand to 60 MW by FY11 and 105MW by FY12 as more husk become available post the expansion of paddy processing capacity. The company has big expansion plans on the solvent extraction front too, whereby capacity would be expanded from the current 200 MT/day to 400 MT/day. It is also expanding its refinery and cattle feed capacities to 60 MT/day (from 30MT/day) and 300MT/ day (from 70/MT day) respectively. The wheat flour plant, its recent foray, will also witness a capacity ramp up from 100 MT/day in FY08 to 300 MT/day. It also recently bought 50 (25 MT) wide body trucks and plans to add 50 trucks in FY2008. The move is to improve its procurement and distribution network. The funding of the expansion plans would be through internal accruals and funding from banks, which given its strong cash generation abilities would not be too difficult to achieve. Thus, given the magnitude of the expansion plans, one can safely conclude that the growth engine will keep on chugging well beyond FY10 and will continue to add significant value to shareholders.

MSP to remain company’s USP: Although the company has done well to augment revenues from by products, the fact remains that rice processing will continue to remain the backbone of the company’s growth well into the future. And it is the positive signals emanating on this front that makes us feel confident about the company’s future growth prospects. Bulk of the company’s rice is sold to the government at a fixed price known as the minimum support price (MSP). Not wanting to hurt the farmer’s purchasing power and also helped by a continuous shortage of foodgrains, the MSPs have seen a strong upward trend in recent times and the same is expected to continue unless yields improve significantly from the current levels. Further, on this rising MSP trend, if one superimposes few of the company’s competitive advantages like an integrated processing plant with significant economies of scale in procurement and selling and strategically located operations, it becomes clear as to why the company’s margins are among the best in the industry. Thus, based on these advantages, there is a high probability that the margins should remain stable or even increase from the current levels. The table below will make it abundantly clear as to why selling rice to government is a more profitable proposition than selling basmati rice.

bRegulated nature of industry: LEAF’s margin in rice processing is a function of MSP fixed by the government for procuring paddy as well as processed rice. LEAF sells 85% of its rice produce to the government agencies. Thus, not only is the profitability of the company at the mercy of government but also there is little scope for the company to expand margins beyond a certain level.

Execution risks: Given the company’s history of project delays, its planned expansion plans may face execution risks, which may hamper its future growth. Also, adverse weather conditions such as inadequate rainfall may pose threat to the availability of significant quantity of paddy at attractive prices.

LEAF, earlier known as Lakshmi Overseas is India’s leading manufacturer of non-basmati rice. Promoted by Balbir Singh Uppal in 1981, the company is one of the largest food grain processing companies in India and in the world. From being predominantly a rice miller, it is transforming itself into an integrated processing company whereby it is commercially exploiting every byproduct coming out of the rice manufacturing process. Through a 5 metric tonne (MT) per hour capacity, LEAF processes 1 m MT of paddy currently. It is located in Punjab, which is one of the largest rice producers in India. Integration, economies of scale and fiscal benefits bestow the company with a huge growth potential

Mr. Balbir Singh Uppal, 53, Chairman and Managing Director. Has 36 years of experience

Mr. I. S. Gumber 50, Director, holds a Bachelor Degree in Science and is also an MBA, LLB, CIIB and CAIB (U.K). He began his association with the company in 2005. Has experience of over 29 years.

Rice is the staple food of majority of the population in India. Moreover, the country is the second largest producer of rice. However, on account of rising consumption and non-improvement of yields, demand is frequently outstripping supply, thus putting pressure on prices. The rice processing industry is regulated. Rice is procured by the government through statutory levy on rice millers and rice dealers. The prices of the levy rice are fixed by the central government. The paddy (as per prescribed specifications) is offered for sale at specified centers and is bought by public procurement agencies at minimum support price (MSP). The MSP is announced every year (Rs 750 per 100 kg in 2007). The producers can either sell their produce to FCI (Food Corporation of India)/ state agencies at MSP (Rs 1,350 per 100 kg in 2007) or in open market. There are 1,39,000 rice processing mills in India for processing 134 m MT of paddy. There are around 6,800 mills in Punjab and the state cultivates around 15 m MT of paddy. The government procures 95% of the rice produced in the state at fixed prices thus reducing the risk for processors.

Sector: LEAF represents the missing link in the paddy-processing segment. Its margin in rice processing is a function of MSP fixed for procuring paddy and the levy price fixed for rice. It is uniquely positioned in two of the fastest growing sectors: Food and Power. Fragmented market provides opportunity for efficient integrated processors and LEAF being the largest stands to benefit. We thus assign a medium risk rating of 6.

Sales: LEAF earned average revenues of US$ 118 m between FY04 and FY07 and revenues to the tune of nearly US$ 174 m in FY07. Further, during FY07 to FY010, the company is expected to generate average annual revenues of US$ 253 m. Based on our parameters, we assign a high-risk rating of 1 to the stock

Current ratio: LEAF’s current ratio in FY07 was 4.4, indicating the company's ability to pay up short-term obligations. A ratio under 1 suggests that the company is unable, at that point, to pay off their obligations if they came due. Also, the company generates adequate cash flows, which is indicative of its sound financial health. We assign a rating of 9.

Long term EPS growth: LEAF’s net profits have grown by 88% CAGR in the past three years. The growth is due to low base effect and capacity expansions. We expect the company's net profit to grow by around 47% CAGR during the period FY07-FY10. Based on a normal scenario, we consider a compounded growth of over 20% in net profits over a period of 3 to 5 years as healthy for a company. As such, the rating assigned to the stock is 9.

Dividend payout: Stable dividend history inspires confidence in the management's intentions of rewarding shareholders. LEAF’s average payout ratio was around 10% in the last three years, which is on the lower side. Thus, the rating assigned is 2

Debt to equity ratio: A highly leveraged business is the first to get hit during times of economic downturn, as companies have to consistently pay interest costs, despite lower profitability. We believe that a debt to equity ratio of greater than 1 is a high-risk proposition. While LEAF’s average debt to equity ratio in the past five years has been higher at 0.6, the average ratio for the next three years is expected to be at 1, led by huge expansion plans. We have assigned a medium risk rating of 5.

Promoter holding: A larger share of promoter holding indicates the confidence of the people who run it. We believe that more than 50% promoter holding indicates safety for investors. At the end of December 2007, this holding stood at marginally over 42%, which is healthy. The rating assigned is 7.

FII holding: We believe that FII holding of greater than 20% can lead to high volatility in the stock price. FII holding currently stands at around 37%. This is risky and we assign a rating of 2

Liquidity: The 52-week average daily volume is in the range of 1,84,209 shares. The impact cost to acquire a large chunk will be high in case of low volumes. LEAF’s volume figures indicate medium risk. The rating assigned is 5.

Margin of safety: This is to determine the value of the stock relative to its price and the returns over a risk free rate. Margin of safety of a stock lies in its earning power, which is calculated as EPS divided by Market price (reciprocal of P/E). Considering LEAF’s P/E of 14.6 times its trailing 12-months earnings, the earning power is 6.8%. This is lower than the risk-free interest rate of 7.9% (10-year G-Sec yield) by 1.1%. Thus, the rating assigned is 1.

Considering the above parameters, the total ranking assigned to the company is 47. This makes the stock a medium-risk investment from a long-term perspective.

The nature of the Indian rice processing industry provides a huge opportunity for the company. LEAF enjoys significant advantage due to its size, higher value by products, cogeneration capacities and fiscal benefits. Further, with government favoring bigger, well-entrenched players in processing, LEAF stands a good chance. On account of the company’s size, its integrated model and excellent growth prospects, we believe that the company deserves an earnings multiple no less than 12 times earnings. At the current price of Rs 268, the stock is trading at a price to earnings multiple of 8.4 times our FY10 estimates. Thus, taking into account multiple of 12 times the company's FY10 earnings, we arrive at a target price of Rs 384, resulting into a CAGR of 19% from the current levels. We thus recommend a 'BUY' on the stock from a FY10 perspective.